Inflation Independent Study:

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Independent Study:

There is a great divide among economists as to the future of inflation within the United States. The recent financial botch gave rise to an arsenal of innovative tactics developed by the Federal Reserve Bank which began the risky journey of expansive monetary policy. As we will discuss in detail later, the Fed has increased the amount of liquidity in the financial system by an unrivaled amount. Never before have we seen such an explosive increase in the amount of dollars being fed to the American economy through asset purchases and interest rate manipulation. The future of both inflation and the dollar remain in question, however there are some metrics that offer a great amount information as to the possible direction of our currency.

During the Great Depression in the 1930’s, the Federal Reserve took a

conservative approach to monetary policy. As unemployment skyrocketed and sentiment plummeted there was little done to stimulate demand within the economy. A restrictive monetary policy reduces aggregate demand within the economy as it reduces the availability of credit (liquidity) needed to purchase capital and consumer goods. Many believe, including the current Fed Chairman Ben S. Bernanke, the Feds actions to tighten the money supply only prolonged the depression by restricting the much-needed liquidity to fuel consumption and capital investment.

As a student of history Bernanke has taken an entirely different approach to solving the financial crisis then did the Fed during the 1930's. The response by the Fed during the 2008/09 crisis has put the dollar in a position where history offers little guidance as to future policy and where economic forecasting has never been more imperative. Never before have we seen such an extraordinary effort by the Fed to halt such a daunting liquidity shortage. Thus, predicting the future state of the Green Back will prove to be a challenge for those whose duty it is to defend the purchasing power of our currency.

Immediately following the collapse of Lehman Brothers on the 16th of September 2008, the credit market all but ceased to function. The cost of borrowing money

overnight for financial institutions was at record highs. The collapse of Lehman brought about a huge amount of distrust in the loanable funds market as lending institutions hoarded reserves as they feared holding short term liabilities on their balance sheets. At

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2 this time, the Federal Reserve was extremely active in implementing new policies aimed at putting out the fire.

Along with changing its current policy in regards to credit and the Federal Funds rate. Among those included the manipulation of the Federal Funds rate. The Federal Funds rate is the rate at which private banks charge one another for the overnight lending of dollars. Since the advent of the crisis, the Fed has lowered their target Fed Funds rate to a historically low range of 0 to 25 basis points (Federal Reserve Bank). This policy encourages cheap movement of funds from bank to bank which in turn lowers the cost of money to those needing credit. Figure 1 below offers visual reference to this policy move.

Figure 1

Influencing bank-to-bank lending rates is one of two primary policy actions the Fed uses to control the cost of money. The other is the discount rate or the rate it charges financial institutions for extending credit to the market. One of the primary reasons the Fed was created was to lend money to the financial system when loanable credit from other financial institutions was unavailable. In this sense, the Fed was created to be the “lender of last resort” when credit runs dry within the financial system. The Fed offers lending through the discount window to institutions in need of surplus capital. The rate at which is lends has been reduced significantly since Sept. 2008 (Federal Reserve Bank). A visual reference is provided in figure 2 below.

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3 0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00 P e rc e n t %

Primary Credit Rate

Source: Federal Reserve 0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00 Pe rc ent %

Primary Credit Rate

Source: Federal Reserve

Figure 2

The most significant change in our central banks policy since the near collapse of the financial system has been the Feds open market operations. The crisis brought about stark policy changes within the Fed’s capacity to manipulate the supply of liquidity. Open market operations within the Fed has expanded to include an assortment of new lending and asset purchasing facilities. These new facilities have expanded the Fed’s reach into the market with the purpose of assuming assets from faulty institutions such as Fannie Mae, Freddie Mac, and American International Group. To this date, the Fed’s actions have been deemed successful as the credit markets have been functioning properly. Evidence of a normal credit market is evident in the TED Spread. This spread is the difference between interbank loans and short term U.S. T-Bills. As of April 1, the spread was just short of 14 basis points (Bloomberg). This follows a high of 463 basis points on October 10, 2008.

The current plight in monetary policy is how and when to begin the extraction of dollars from the U.S. economy. As of August of 2008, the amount of all dollars in

circulation had totaled roughly $871 Billion. As of February 2010 the Fed’s balance sheet totaled $2,183Billion (Federal Reserve Bank). The net change in the Fed’s Balance sheet equates to roughly 250.6% growth from pre- crisis to February 2010. Figure 3 below shows us the net change in the monetary base.

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4 $-$500 $1,000 $1,500 $2,000 $2,500 B ill io n s o f $

Monetary Base

$-$500 $1,000 $1,500 $2,000 $2,500 B ill ions of $

Monetary Base

Figure 3

Given the market for credit within the U.S. financial system appears to be functioning at a normal pace; it’s now a matter of how and when policy makers should begin the extraction of the extra funds. The argument for how to wind down the Feds balance sheet is arguably less important than the when. The "when" is contingent upon the state of demand within the economy, the "how" is contingent on the chairman of the Feds capacity to efficiently withdrawal money from a fragile financial system.

The expansion of the monetary base has yet to have any significant effect on the supply of money. Prior to the expansion of the monetary base, the currency portion of the Feds balance sheet comprised of roughly 95% of total outstanding liabilities. Since the expansion, the currency portion has remained steady while bank reserves have increased 20 fold (Laffer, 2009). Figure 4 gives visual reference to the amount of reserves held in excess of required reserves by depository institutions. The increase in the level of reserves held by financial institutions with the Federal Reserve accounts for much of the increase of the monetary base as figure 4 depicts.

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5 $-$200 $400 $600 $800 $1,000 $1,200 $1,400 B ill io n s o f $

Reserves Held In Excess of Required Reserves

Source: Federal Reserve $-$200 $400 $600 $800 $1,000 $1,200 $1,400 B ill ion s of $

Reserves Held In Excess of Required Reserves

Figure 4

Figure 5 displays M2 which is composed of currency, traveler’s checks, demand deposits, small-denomination time deposits, small-demonization time deposits, and retail money funds (research.stliousfed.org). The stock of money within the economy has not shown any significant increase since the onset of the crisis. Again this has much to do with the level of reserves financial institutions are currently sitting on. Any excess capital lending institutions have to lend has yet to finds its way into the hands of businesses and consumers as demand for credit has yet to gain momentum.

$6,000 $6,500 $7,000 $7,500 $8,000 $8,500 $9,000 M 2 (B ill io n s o f $ )

Money Stock

$6,000 $6,500 $7,000 $7,500 $8,000 $8,500 $9,000 M 2 (B ill ions of $ )

Money Stock

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6 Another metric that measures the relative supply of money in the economy is the velocity of money (M2/GNP). This ratio measures the speed at which money is being utilized to purchase goods and services within the economy. Recently, the velocity of money has had no significant increase and does not appear to be trending up or down. Velocity is equal to the price level times the quantity of output divided by the money supply (V=P*Q/M). As it stands, prices within the economy have remained constant. Thus, the only difference in today’s velocity ratio as it compares with the pre-crisis velocity is the change in the quantity of output and the money supply. The money supply has increased by a small amount (Figure 5), however output has fallen. The velocity of money will not increase until “Q” rises in relation to “M”. From this we deduce a change in the money supply has not met the change in the quantity of output. If “Q” should suddenly increase, there will likely be an increase in “V”. However, if “V” remains constant and “Q” increases then “P” must increase, thus if “P” increase’s, then we have rising price levels or inflation.

1.55 1.6 1.65 1.7 1.75 1.8 1.85 1.9 1.95 2 M 2 /G N P

Velocity of Money

1.55 1.6 1.65 1.7 1.75 1.8 1.85 1.9 1.95 2 M 2/ G N P

Velocity of Money

Figure 6

It is widely expected the current fiscal and monetary stimulus will eventually lead to an overall recovery of demand within in the economy. The need for loanable funds is suppressed as business manager’s fear that demand for their goods and services will not return. This is evident by the amount of commercial loans being granted by lending institutions. Figure 7 below tells the story of the collapse in demand for credit from

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7 banks. As consumer sentiment dropped significantly after the collapse of Lehman,

business managers carefully began to draw down business operations. In recession periods, holding too much debt posses a significant threat of default as lagging demand for products slows cash flows. The inability to repay creditors results in the liquidation of assets which often limits a company’s ability to exist as they once were. This threat of default has significantly decreased the demand for credit as the figure below depicts.

$800 $900 $1,000 $1,100 $1,200 $1,300 $1,400 $1,500 $1,600 $1,700 $1,800 B ill io n s o f $

Commercial and Industrial Loans

$800 $900 $1,000 $1,100 $1,200 $1,300 $1,400 $1,500 $1,600 $1,700 $1,800 Bi lli on s of $

Commercial and Industrial Loans

Figure 7

There is considerable disagreement among economists as to the near term future of inflation. Many agree the future of inflation is strictly contingent on the growth of the money supply. When growth of the money supply exceeds growth in GDP than inflation will exude as too much money is chasing too few goods. This doctrine seems to offer valid assumptions; however growth in the money supply is yet to be realized since lending institutions have yet to lend at their full capacity.

The question now becomes at what point will demand for money surface within the economy. The demand for money is highly contingent on the aggregate demand. New money is created when lending institutions supply credit to the market. As discussed earlier, the demand for credit at the moment is not at levels high enough to put upward pressure on price levels. In order to decipher the future demand for money, we must look at two metrics that serve as great indicators for shifts in aggregate demand.

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8 The personal economic position of the consumer can be measured through a number of metrics. At the moment, one of the most comprehensive of all metrics is labor market. Since the advent of the crisis, unemployment has risen to a high of 10.2%. The rate of unemployed has since fallen to 9.7% as of March 2010 (BLS). There is skepticism as to what the unemployment numbers convey as there is evidence of individuals who have been unemployed for an extended period are leaving the labor market as hopes in finding employment falters. Nonetheless, a sagging labor market will conflict

considerable damage on the future spending habits of consumers as payrolls drop. Growth in unemployment is the key to supplying the economy with cash earned from newly acquired jobs. Figure 8 below highlights the current employment situation.

Figure 8

According to Lorimer Wilson director of marketing and contributing editor of www.preciousmetalswarrant.com; “It is just a matter of time, as well, before consumer spending recovers and bids on now-depleted inventories causing prices to rise for pure supply and demand reasons.” The prospects of inflation in the coming quarters seem to remain contingent on the state of the consumers spending habits as Mr. Wilson pointed out. It’s widely known that roughly 70% of the U.S. economy is driven by the consumer-spending variable within the GDP formula. Thus, the state of aggregate demand within the economy is subject to state of the consumer.

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9 Figure 9 shows the University of Michigan’s consumer sentiment index. The state of consumer spending depends heavily on the overall sentiment of consumers. As

sentiment on the future state of the economy rises so too does the consumer willingness to spend. Since the development of the crisis, sentiment has fallen sharply as consumers pocket a larger portion of their take home income. Figure 10 shows the change in the consumer behavior as it pertains to the savings rate. As sentiment falls savings increases’ slowing growth in retailing spending and thus shifting the aggregate demand curve to the left. For now, as shoppers restrain spending, significant growth in capital demand from businesses is very likely to remain limited. However, should consumer sentiment

continue to rebound, it may not be long before spending levels match the pre-crisis levels.

40.0 50.0 60.0 70.0 80.0 90.0 100.0 In d e x

U of M Consumer Sentiment

Source: University of Michigan 40.0 50.0 60.0 70.0 80.0 90.0 100.0 In de x

U of M Consumer Sentiment

Source: University of Michigan

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10 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 P e rc e n t o f T o ta l In co m e

Personal Savings Rate

Source: Bureau of Economic Analysis 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 Pe rc en t o f T ot al In co m e

Personal Savings Rate

Source: Bureau of Economic Analysis

Figure 10

Beyond the consumer, aggregate demand is influenced greatly by conditions within the housing market. According to Yi Wen, the housing market strongly leads the business cycle. According to Mr. Wen, increases in home purchases, and in particular new home purchases, leads to increased demand for durable goods such as furniture, building materials, yard supplies… etc. As long as the Fed maintains its current policy regarding interest rates, the housing market should continue feeling increasing pressure on housing prices. Figure 11 highlights the Case-Shiller housing price index which tracks the values of homes in the 20 largest metropolitan cities. As aggregate demand shifts to the right, aggregate price levels should begin feeling increased pressure as buyers re-enter the market. An increase in the price of homes represents an increase of buyers entering the market. As buyers enter the market, housing inventories begin to fall and the need to fill new homes with supplies rises.

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11 100.0 120.0 140.0 160.0 180.0 200.0 220.0 In d e x 2 0 0 0 = 1 0 0

Case-Shiller Housing Price Index 20

Metro Composite

Source: Standard & Poors

100.0 120.0 140.0 160.0 180.0 200.0 220.0 In de x 20 00 = 1 00

Case-Shiller Housing Price Index 20

Metro Composite

Source: Standard & Poors

Figure 11

Based upon the data above and the research compiled for the writing of this report, it is clear that inflation is not likely to be a threat in the 3rd and 4th quarters of 2010. A return to normalcy in the housing market is likely to take much longer then some may believe. The Federal Stimulus program aimed at providing first time home buyers with tax credits is not sustainable and will at some point come to an end. To quote the infamous Robert Shiller when asked by Charlie Rose in a recent interview whether or not he thought the housing market was being supported by the governments recent actions he responded, “Well, it’s 80% or 90% supported. Really almost the whole market now is government. And we know this can’t last.” When these tax credits and other government intervention program cease to encourage home purchases, it’s possible demand for

housing will slip yet again prolonging the housing downturn. The influence of housing on aggregate demand is substantial and policy makers should monitor the nature of the housing market.

Consumer spending within the economy has slowed dramatically but does show signs of strengthening to pre-crisis levels. Moving forward, it’s not likely consumers will jump back into their old spending habits. Record federal budget deficits and uncertainty of future tax laws is likely going to keep consumers a bit more fiscally conservative for time to come. Uncertainty in regard to the future is often a powerful incentive for consumers to act in a conservative fashion as is likely the case as it stands now.

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12 The final two quarters of 2010 are likely to be normal in terms of aggregate price inflation. Normal, in this regard, is 2-3% increases in the consumer price index. Should we experience hiccup in the recovery (as Robert Shiller and others suggest) inflation will pose no threat in the near term. If the recovery continues as it is now, policy makers will need to begin sopping up funds from the market.

Looking forward, it would seem unreasonable to expect run-away inflation in the 3rd and 4th quarters of 2010. Aggregate demand within the economy has yet to return to normal. Lenders are continuing to stockpile reserves with the Fed. The economy is on the mend, but at a pace much slower then former recessions. The labor market should see modest growth in the coming quarters but nothing that will ignite a furry of consumer spending. The housing market seems to have bottomed temporarily but has yet to show significant signs of a immediate recovery. Until we see a significantly improved labor and housing market should the Fed begin the process of selling assets back to the market and raising interest rates.

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13 Works Cited

Bloomberg (2010, March). Retrieved April 13, 2010, from

http://www.bloomberg.com/?b=0&Intro=intro3

Bureau of Labor Statistics (2010, March). Retrieved March 13, 2010, from

http://www.bls.gov/

Economic Research Federal Reserve Bank of St. Louis (2010, March). Retrieved March

13, 2010, from http://research.stlouisfed.org/fred2/

Federal Reserve Bank (2010, March). Retrieved March 13, 2010, from

http://www.federalreserve.gov/

Laffer, A. B. (2009, June 11). Get Ready for Inflation and Higher Interest Rates. Retrieved February 1, 2010, from

Rose, C. (2010, April 12). [Interview with Robert Shiller]. Bloomberg BusinessWeek, 13-14.

Wen, Y. (2010, March). Money Supply, Credit Expansion, and Housing Price Inflation. Retrieved March 13, 2010, from

http://research.stlouisfed.org/publications/mt/past/2010/

Wilson, L. (2009, July 12). Worried about Future Inflation? Don't Be. Retrieved March 1, 2010