Thursday, June 04, 2009

SMACKDOWN WEEK: Now consumers are all but extinct

Today on SMACKDOWN we'll look at just how inflationary the Fed's programs have been to date.

My premise remains that consumer inflation occurs because consumer spend more nominal dollars. I won't go over the rationale for this viewpoint right now, you can read it here or here. Given this, any program will only be seen as inflationary if it puts cash into consumer pockets, or at the very least, results in goods being purchased.

The headline grabbers are stories like this one at the New York Times. They throw out numbers like $12 trillion and we all cry out inflation! But a large percentage of these figures are asset guarantees, such as the money market insurance program. These programs are clearly not inflationary as they never even involved any exchange of cash.

In order to see how much money may actually go into the economy, let's take a real look at the Fed's balance sheet. We know it has exploded in size:

We also know that most of the Fed's outlays have been funded by crediting bank reserves. That is, the Bernanke's old "electronic printing press." If printing money makes you shudder, you aren't alone.

But remember, even printing money doesn't cause inflation unless that money reaches consumers. I've said before: if the Fed mints a quadrillion new Sacagaweas and just sticks them in a vault at Ft. Knox, there is no inflationary impact.

Alright so what's in the Fed's balance sheet? What have they buying with all that printed money? (All figures represent an increase).

I've color coded this based on inflationary impact. The various shades of blue are non-inflationary. Starting at the top and moving to the left, the first is the Maiden Lane transactions. These are all related to Bear Stearns and AIG bailouts (note I added some AIG-related loans that technically aren't part of Maiden Lane LLC into this figure). Can't see how these impact inflation in any meaningful way. The next is related to dollar swaps with foreign central banks. Again, while I think this helps provide meaningful liquidity to the worldwide financial system, the impact on consumer inflation is minimal, even if the Fed is "crediting reserves" to help provide the cash. Finally we have "other" Fed activity, which involves stuff like the Fed's gold stock. Not an issue.

Term Auction Debt and the CP/money market programs are a little more nebulous. These plus the actual discount window is in green. The Term debt is mostly the TAF and the TSLF, both of which were meant as quasi-discount window loans to banks and primary dealers. Neither is as heavily used as it was in late 2008. I'd argue that the these term loans are merely replacing other types of borrowing that would otherwise have occurred in the capital markets. So while it is interfering in markets, it isn't inflationary. The commercial paper program is similar. If it just replaces private sector borrowing, it isn't inflationary.

Now wait a minute, you say, the market is over-leveraged. This kind of short-term debt is what helped get us into this mess! The private sector should be winding down! The Fed shouldn't be encouraging short-term borrowing of this nature. That's besides the point when you are thinking about inflationary impact. Inflation (or deflation) is caused by the change in effective money supply from one period to the next. If all the debt was suddenly drained from the system, it would surely be severely deflationary. So to the extent the Fed is substituting its own balance sheet for private lending, that's a neutral event in terms of inflation. Indeed, according to the Fed, financial debt grew at a 6% pace last year, down from 12% in 2007 and the slowest pace since 1991.

The other programs (in yellow) do have some inflationary impact. Securities held directly are, most notably, the Fed's mortgage, agency, and Treasury buying programs. (I've subtracted the decline in repo from this figure, since these new programs really replace the Fed's old repo-based programs.) When the Fed buys bonds, they are buying them from someone, and that cash eventually makes it into the system. I've argued that in fact, securities purchases are just a convenient means of pumping dollars into the economy. So it seems that an inflationary result is the goal.

Same with the TALF. The idea behind the TALF is to restart the ABS markets, which would provide cash directly for credit-based consumption. This is practically printing money and giving it to consumers. However, for better or worse, the TALF has been little used. It was supposed to be up to $1 trillion. It would be just as well to let him go, he's too far out of range.

Now let's add up the "inflationary" increase in the Fed's balance sheet. $528 billion.

Now let's compare that with some other key indicators of consumer behavior. The chart below compares the increase in the Fed's programs with the decrease in the other indicators. The decreasing elements have been inversed to illustrate the relative size.

The amount of inflationary Fed programs is slightly larger (in the scheme of the overall economy) than the decline in nominal GDP, consumer debt, and consumer spending. Now none of these figures are directly comparable, i.e., you can't say the inflationary impact is simply x - y. But comparing the relative size of each of these gives some sense of context.

Now if we add the decline in household assets...

Suddenly the Fed's activity seems like a drop in the bucket. And that figure is only through 12/31/08. We don't yet have the Fed's Flow of Funds report through 1Q. We know that household assets are continuing to decline, as evidenced by the continued drop in home prices.

Now we know that eventually consumers will regain their footing and start to spend (and borrow) again. So even if you agree that the Fed's actions aren't inflationary for now, they may become inflationary once the economy starts recovering. So its all about the exit strategy. That will be next time, on SMACKDOWN!


In Debt We Trust said...

You make a sound argument. But then why are commodities rallying if not for the dollar falling?

Is that mere risk aversion turning into risk taking or real fears of a dollar debasement?

Henry Bee said...

Looking forward to the next post!

In Debt We Trust said...

Another thing to consider is next week's big auction. Supply concerns
(especially on the 10 and 30 year dates)?

Don't get me wrong, I agree w/the deflation argument in theory but it's hard not to watch the rapid climb in yields.

Accrued Interest said...


I think the dollar trends weaker because A) The ECB isn't being aggressive enough, so their deflation outlook is even worse than ours, and B) Most EMG currencies are more stable, and thus relatively better off. But I don't see it as a massive slide.

I do think the sell-off is related to fears over debasement though, and therefore if I were to spec, I'd be long.

Unknown said...

Here in the UK, we import most of our automotive equipment, as well as other stuff. With our GBP currency weak, I am suffering extreme sticker price shock on spare parts. I am therefore buying fewer items but paying more per item. This is textbook stagflation.
However a foreign observer measuring us say in SDRs will see lower volumes (recession) but flat-to-lower real prices (compressed import margins).
Although relative money supply growth may affect the exchange rate long term, the short term relationship is not so clear. So it is possible to have inflation (=monetary erosion) independent of all other variables such as capacity utilisation or bank balance sheets.

Kevin S said...

A very good piece. I think it is necessary, however, to draw a distinction between inflation in the real economy and inflation in asset markets. I agree 100% that there is hardly any risk of inflation in the cpi data for years. But once mark-to-market was eased, it allowed cap ratios to increase at the Primary Dealers... it ended asset de-leveraging/forced selling completely. Factor that in with various Fed pumping programs and it was guaranteed to give the markets a huge boost from the lows. So i view the direction of the markets as independent from the real economy for now. It is a matter of liquidity being able to finally seep into the markets.

The next test is whether the banks will have to start selling off their comm real estate/credit card loans. That would then offset much of the Fed pumping as would Treasury borrowing.

In Debt We Trust said...


Thanks for the response. I think there are 2 developments worth watching in related markets:

a) Fed Fund futures
b) Eurodollar futures

Commitment of Traders futures data will be a strong indicator of which way institutions are tipping their hand.

I am not as familiar w/the action in A) as I am in B) (and even then I am just beginning to monitor it).

Noble said...

excellent piece and thanks for the last graph.

In a conversation at dinner about a year ago (pre lehman) I had mentioned to a friend that the Fed needs to print money to recompense for all the lost household wealth. He thought I was nuts.

Essentially this was an off-the-cuff conversation where I asked him to consider a world in which dollars are being destroyed (by hard asset prices falling). Consumers took money out of their homes (HELOCs) right before the values of those homes crashed - creating not just paper wealth destruction but actual wealth destruction. If the Fed were to temporarily "create" money to replace this lost wealth (not completely replace it - since those dollars are still floating around) then the effects would be non-inflationary.

Technically the Fed could hold those securities till maturity or till asset prices came back and we wouldnt have a problem with inflation. Thats exactly what the Fed did in creating a bunch of programs (TALF etc). As you indicate in your last paragraph - the game is now all about the exit strategy. Will the Fed be able to exit in time?

SS said...

Add increasing bank reserves and slowing velocity of circulation and you have deflation at least until next year.


Salmo Trutta said...
This comment has been removed by the author.
Salmo Trutta said...

Definitions of the money supply are not timeless. The extension of the scope and practices of the Federal Government, accompanied by Federal Government guarantees, assures, e.g., a secondary market for some areas of the housing market - which is the "store of purchasing power" attribute of "money".

I.e, there are various types of "tertiary money". These assets possess general "liquidity". They do not bear a direct, unit for unit, relationship to the primary "money supply".

The "force of law" (Obama's job fighting programs) establishes a new and inflationary classification of tertiary money --- money underwritten, insured, and guaranteed, by the credit and faith of the U.S. Government.

Romandière said...


I'm struggling a while already with the interpretation of the FED's balance sheet.
Could you help me out here?

I read interpretations that focus exclusevily on the asset side and forget the liability side of the balance sheet.

On the liability side I see twoo components that changed: the financiing from US Treasury and the reserve balance. Mainly the latter is important as it increased from 10 B to 855 B since August 7.

As far as my knowledge reaches, I interprete this as that commercial banks have deposited excess reserves at the FED who now operates as the pivot point for interbanking lending (instead of banks lending at each other). Risk is now concentrated at the FED level. The FED pays an interest on the reserves to stimulate banks with excess reserves to deposite them.
This money can be used by the FED to finance programms to liquidify the market. It has no impact on the money in circulation, and only aims at circulation itself.

I think this amount has to be deducted from the assets that could be inflationary.


GestaltU said...

I think it is important, as others have mentioned in these comments, to differentiate between goods inflation and asset price inflation. For those who operate strictly in the debt market, asset inflation is of significantly less practical importance because the focus is on real rate spreads on credit, which are defined relative to CPI.

For investors in broader asset markets, inflation definitions take on greater practical importance. One way of looking at inflation is too many dollars chasing fewer goods. Another definition involves too many dollars chasing too little productivity investment. This can be quantified by a measure called the Marshallian K.

Without going into too much detail, Marshallian K is the ratio of growth in the monetary base relative to growth in GDP. If companies can not achieve a positive return on investment in projects that expand economic output (due to overcapacity), but the money supply is expanding anyway, the excess dollars will find their way to asset markets and push asset prices higher. This is a useful definition of asset price inflation.

Eventually, the wealth effect of asset price inflation may cause consumers to borrow against their wealth for current spending, and this will push the price of goods higher. In this way, asset price inflation can cause CPI inflation even in the absence of real productivity growth, or real growth in GDP per capita.

Comments welcome.


Unknown said...

This is a much more nuanced "power of small" take on the Fed's inflationary policies. Most people seem to think that everything the Fed is doing now is causing inflation. Thanks for delving into the details.