Federal Reserve

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Where are the customers' rate increases?

Published by Anonymous (not verified) on Wed, 27/04/2022 - 7:17am in

U.S. banks are at it again. Inflation is at its highest level in decades. At the same time, interest rates on deposits at the Fed, Treasury bills, bonds and mortgages are rising rapidly to compensate. Yet banks are still in a holding pattern when it comes to the interest rates they pay to customers on savings accounts, certificates of deposit (CDs), and interest-checking accounts.

Here's the chart, which uses FDIC data from FRED. Note how customer deposit rates (in red) have hardly budged, despite the Fed beginning to raise rates last summer. This same sluggishness also occurred in 2015, the last time the Fed began to hike rates. Banks didn't boost savings accounts rates till two years later, in 2017!

 

Historically, rates on CDs seem a little more responsive. But they're still sluggish. The average 6-month CD still only yields a scrawny 0.09%, whereas the yield on a 6-month Treasury bill is now at 1.4%.

This stickiness wouldn't be such a big deal if banks were also slow to reduce interest rates on customers' accounts – win some, lose some, right? But take a look at what happened when the Fed began to cut rates in mid-2019. Banks didn't hold off. They immediately started to pass lower rates on to their customers, and only became more aggressive when COVID hit in March 2020.

So for bank depositors, it's all lose. U.S. banks are slow to increase rates on checking accounts, CDs, and savings accounts, but quick to reduce them. I wrote about this sad lack of symmetry back in 2020. Do go back and read it.

This observation isn't something that economists have ignored. In a paper entitled "Sticky Deposits", Federal Reserve economists John Driscoll & Ruth Judson found that rates are "downwards-flexible and upwards-sticky." This stickiness has consequences for regular Americans. If rate stickiness didn't exist, the authors estimate that U.S. depositors would have received as much as $100 billion more in interest per year!

The Fed’s Balance Sheet Runoff and the ON RRP Facility

Published by Anonymous (not verified) on Thu, 14/04/2022 - 2:20am in

 Finance and banking concept. Euro coins and us dollar banknote close-up. Abstract image of Financial system with selective focus, toned, double exposure.

A 2017 Liberty Street Economics post described the balance sheet effects of the Federal Open Market Committee’s decision to cease reinvestments of maturing securities—that is, the mechanics of the Federal Reserve’s balance sheet “runoff.” At the time, the overnight reverse repo (ON RRP) facility was fairly small (less than $200 billion for most of July 2017) and was not mentioned in the post for the sake of simplicity. Today, by contrast, take-up at the ON RRP facility is much larger (over $1.5 trillion for most of 2022). In this post, we update the earlier analysis and describe how the presence of the ON RRP facility affects the mechanics of the balance sheet runoff.

Simplified Balance Sheets

In the exhibit below, we describe simplified balance sheets for the Fed, the Treasury, banks, and money market funds (MMFs). We only show the balance sheet items that are essential for understanding the mechanics related to the Fed’s actions. In a follow-up post, we consider the role of levered nonbank financial institutions and households.

  • On the Fed’s balance sheet, the asset side contains Treasury securities; on the liability side, there are reserves held by banks, cash balances held by the Treasury in its “checking account” at the Fed (the Treasury General Account, or TGA), and ON RRP balances held by MMFs.
  • On the Treasury’s balance sheet, the asset side contains balances in the TGA; on the liability side, there are Treasury securities.
  • On banks’ balance sheet, the asset side contains Treasury securities and reserves held at the Fed; on the liability side, there are deposits held by MMFs (for example, transaction deposits as well as overnight and term deposits placed in wholesale funding markets).
  • On MMFs’ balance sheet, the asset side contains Treasury securities, deposits at banks, and investments in the ON RRP facility; on the liability side, there are MMF shares held by households. In contrast to banks and the Treasury, MMFs cannot hold balances in a Fed account; however, MMFs have access to the ON RRP facility (MMFs with ON RRP access accounted for approximately 80 percent of MMF assets under management at the end of 2021).

 Federal Reserve, Treasury, Banks and MMFs with two columns representing assets and liabilities.

We start by showing what happens when Treasury securities held by the Fed mature, the Fed doesn’t reinvest the proceeds of the maturing securities, and the Treasury does not issue new securities. In this case, depicted in the next exhibit, the Treasury pays the Fed with cash from the TGA as the securities mature. The Fed holds fewer assets (its holdings of Treasury securities decrease) and has fewer liabilities (cash held by the Treasury at the Fed decreases), so the size of its balance sheet decreases.

 Federal Reserve, Treasury, Banks and MMFs with two columns representing assets and liabilities.

For the remainder of the post, we assume that when $1 worth of Treasury securities held by the Fed matures, the Treasury issues $1 worth of new securities, so the size of the Treasury’s balance sheet remains unchanged. To make things simple, we assume that new securities are issued at the same time as old securities mature.

Banks Purchase Newly Issued Securities

We now consider what happens when newly issued Treasury securities are purchased by banks (see exhibit below).

Two transactions occur simultaneously:

  • As in the previous exhibit, the Treasury repays the Fed for the maturing securities, which reduces the TGA balance and the Treasury securities held by the Fed by the same amount. In all subsequent exhibits in this post, the sequence of transactions includes this step of the Treasury repaying the Fed. In the interest of simplicity, we won’t mention this step again.
  • Banks purchase the new securities issued by the Treasury, with banks transferring balances to the Treasury in exchange for the securities. As banks transfer money to the Treasury, the TGA balance goes back to its original level.

At the end of this process, the size of the Fed’s balance sheet has decreased with a reduction of Treasury securities on the asset side and reserves on the liability side; the Treasury’s balance sheet is unchanged; and the size of banks’ balance sheet is the same but the composition of assets is different (higher holdings of Treasury securities and lower reserves).

 Federal Reserve, Treasury, Banks and MMFs with two columns representing assets and liabilities.

MMFs Purchase Newly Issued Securities

We next consider what happens when newly issued Treasury securities are purchased by MMFs. MMFs can fund their purchases by withdrawing deposits at banks, reducing their investments in the ON RRP facility, or a combination of the two. The next exhibit shows what happens if MMFs use both deposits and ON RRP investments to purchase Treasury securities.

Several transactions occur simultaneously:

  • MMFs buy new securities from the Treasury, which holds the proceeds at the Fed, returning the TGA balance to its level before the Treasury securities held by the Fed matured.
  • MMFs’ deposits at banks decrease as MMFs use them to purchase a portion of the Treasury securities. Banks facilitate the purchase, transferring reserve balances to the TGA while debiting the accounts that MMFs have at the banks.
  • MMFs reduce their investments in the ON RRP facility to fund the purchase of the remainder of the Treasury securities. ON RRP balances decline and the TGA balance increases by an equal amount.

Banks’ balance sheet shrinks, with lower deposits on the liability side, and lower reserves on the asset side. The size of MMFs’ balance sheet is unchanged, but its composition on the asset side has changed: the increase in Treasury securities holdings is offset by a decrease in deposits held at banks and investments in the ON RRP facility.

Since MMFs can only buy newly issued Treasury securities if they are Treasury bills or floating rate notes, only when these securities are issued in large amounts will MMFs be able to absorb a large fraction of the Fed’s balance sheet reduction. Moreover, the extent to which MMFs are willing to buy Treasury securities depends on how the rates on these securities compare to the rates paid on alternative assets such as bank deposits and ON RRP investments. Finally, since a large fraction of the MMF industry—namely government funds—cannot invest in bank deposits, it is likely that a large proportion of purchases of Treasury securities by MMFs would be financed through reduced investments in the ON RRP facility.

 Federal Reserve, Treasury, Banks and MMFs with two columns representing assets and liabilities.

Banks and MMFs Purchase Newly Issued Securities

Finally, we illustrate the case where some of the new Treasury securities are purchased by banks and some by MMFs. The next exhibit shows what happens when banks and MMFs each purchase half of the new issuance, and MMFs purchase the securities by drawing down a combination of deposits at banks and investments in the ON RRP facility. The description of the transactions corresponding to the exhibit is similar to the ones described above and left as an exercise for the reader.

 Federal Reserve, Treasury, Banks and MMFs with two columns representing assets and liabilities.

Conclusions

In this post, we updated an earlier post illustrating the balance sheet mechanics of a runoff in the Fed’s holdings of Treasury securities to illustrate the effect of the ON RRP facility. In all cases, the Fed’s balance sheet decreases as the Fed doesn’t reinvest the proceeds of its maturing Treasury securities. On the liability side of the Fed’s balance sheet, the decrease may stem from either a reduction of reserves held by banks or a reduction in ON RRP take-up or a combination of both. Similar mechanics occur when agency mortgage-backed securities mature and banks purchase the newly issued securities, as was noted in this Liberty Street Economics post. As the exhibits in this post show, the runoff of the Fed’s security holdings has potential implications for the balance sheets of a range of financial market participants.

Marco Cipriani

Marco Cipriani is an assistant vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.

James Clouse is a deputy director in the Division of Monetary Affairs at the Board of Governors of the Federal Reserve System.

Lorie Logan

Lorie Logan is an executive vice president in the Federal Reserve Bank of New York’s Markets Group.

Antoine Martin

Antoine Martin is a senior vice president in the Bank’s Research and Statistics Group.

Will Riordan

Will Riordan is an assistant vice president in the Bank’s Markets Group.

How to cite this post:
Marco Cipriani, James Clouse, Lorie Logan, Antoine Martin, and Will Riordan, “The Fed’s Balance Sheet Runoff and the ON RRP Facility,” Federal Reserve Bank of New York Liberty Street Economics, April 11, 2022, https://libertystreeteconomics.newyorkfed.org/2022/04/the-feds-balance-s....


Disclaimer
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

The Fed’s Balance Sheet Runoff: The Role of Levered NBFIs and Households

Published by Anonymous (not verified) on Thu, 14/04/2022 - 2:19am in

 Finance and banking concept. Euro coins and us dollar banknote close-up. Abstract image of Financial system with selective focus, toned, double exposure.

In a Liberty Street Economics post that appeared yesterday, we described the mechanics of the Federal Reserve’s balance sheet “runoff” when newly issued Treasury securities are purchased by banks and money market funds (MMFs). The same mechanics would largely hold true when mortgage-backed securities (MBS) are purchased by banks. In this post, we show what happens when newly issued Treasury securities are purchased by levered nonbank financial institutions (NBFIs)—such as hedge funds or nonbank dealers—and by households.

Simplified Balance Sheets

In the exhibit below, we describe the simplified balance sheets for the Fed, banks, MMFs, NBFIs, and households. We only show the balance sheet items that are essential for understanding the mechanics related to the Fed’s actions.

Initial Conditions

  • On the Fed’s balance sheet, the asset side contains Treasury securities; the liability side contains reserves held by banks and funds invested by MMFs in the Overnight Reverse Repurchase Agreement (ON RRP) facility.
  • On banks’ balance sheet, the asset side contains Treasury securities, reserves held at the Fed, loans, and (reverse) repurchase agreements (repos) with NBFIs; the liability side contains deposits from households.
  • On MMFs’ balance sheet, the asset side contains Treasury securities, investments in the ON RRP facility, and (reverse) repos with NBFIs; the liability side contains MMF shares held by households. In contrast to banks, MMFs cannot hold balances in a Fed account. Note that in contrast to our previous post, for simplicity’s sake, MMFs do not hold bank deposits (indeed, as we remarked in our previous post, government MMFs, the largest segment of the MMF industry, are not allowed to hold deposits).
  • On NBFIs’ balance sheet, the asset side contains Treasury securities; the liability side contains repos with banks and MMFs, loans, and cash balances from households. Note that we focus on levered NBFIs—that is, NBFIs that finance a substantial proportion of their assets through debt (for example, by borrowing in the repo market); other NBFIs (such as open-ended mutual funds or pension funds) are un-levered and they fund most of their asset purchases with cash balances from households.
  • Finally, on households’ balance sheet, the asset side contains Treasury securities, deposits at banks, MMF shares, and cash balances at NBFIs. The liability side of the balance sheet contains loans and the difference between assets and liabilities is households’ net worth.

We assume that $1 worth of Treasury securities held by the Fed matures and the Treasury issues $1 worth of new securities. In this post, the new securities are purchased by NBFIs or households and the Treasury uses the proceeds of the newly issued debt to meet the Fed’s redemptions. For this reason, the Treasury’s balance sheet remains unchanged, and therefore, we can ignore it.

Levered NBFIs Purchase the Newly Issued Securities

We first consider the case in which levered NBFIs purchase the newly issued securities (see exhibit below).

Levered NBFIs Purchase New Treasury Securities

Several transactions happen at the same time:

  • NBFIs finance the purchase of the new securities through repos from banks ($0.5) and MMFs ($0.5), with the newly issued securities as collateral. The size of NBFIs’ balance sheet increases by $1: on the asset side, they hold more Treasury securities; on the liability side, their repos have increased by the same amount.
  • Banks lend to NBFIs through (reverse) repo contracts. The size of banks’ balance sheet is unchanged, but the composition of bank assets is changed (lower reserves, higher repo lending).
  • Similarly, MMFs lend to NBFIs through (reverse) repo contracts. The size of MMFs’ balance sheet is unchanged, but the composition of MMF assets is changed (lower ON RRP balances, higher repo lending). Note that, similarly to our previous post, MMFs could also lend to NBFIs by using their deposits with banks (not shown in the exhibits), in which case the size of banks’ balance sheet would shrink.
  • At the end of this process, the size of the Fed’s balance sheet has decreased. The asset side contains fewer Treasury securities ($1); on the liability side, there is a reduction of reserves held by banks ($0.5) and ON RRP take-up ($0.5).

In this example, NBFIs are the only private-sector entities to increase their security holdings, and since we are considering levered NBFIs, they fund the purchases solely through borrowing in the repo market; this implies that as a result of the runoff, leverage in the financial system has increased. As we mentioned above, there are other NBFIs (such as open-ended mutual funds or pension funds) that are un-levered and that would fund their purchase of Treasury securities by either selling other assets or increasing the amount of cash balances they receive from households.

Households Purchase the Newly Issued Securities

We now consider the case in which households purchase the newly issued securities (see exhibit below).

Households Purchase New Treasury Securities

Households have different levels of wealth. It is likely that not all households invest in the same set of financial assets; for instance, while many households may have their savings in bank deposits and MMFs, only wealthier households are likely to invest in levered NBFIs, like hedge funds.

  • As households are heterogeneous and likely keep their savings in different types of assets, in our example we assume that in the aggregate they fund the purchase of new Treasury securities by reducing their deposits with banks ($0.5), their holdings of MMF shares ($0.25), and their cash balances with NBFIs ($0.25). The size of households’ balance sheet is unchanged, but the composition of household assets is changed (increased holdings of Treasury securities; lower deposits at banks, lower holdings of MMF shares, and lower balances placed in cash accounts with NBFIs).
  • MMFs react to the reduction of households’ investment by reducing their ON RRP take-up. MMFs’ balance sheet shrinks; assets are lower by $0.25 (lower ON RRP take-up) and so are liabilities (fewer shares).
  • Levered NBFIs make up for the reduction of households’ cash balances ($0.25) by borrowing from banks. Note that although NBFIs could also borrow from MMFs (as in the previous case), for simplicity’s sake we assume that they do not do so. The size of NBFIs’ balance sheet is unchanged, but the composition of NBFIs’ liabilities is changed (lower cash balances, higher loans from banks).
  • Banks reduce their reserves ($0.5) in response to the decline in households’ deposits. Banks also issue loans to NBFIs ($0.25) that cover the loss in funding of NFBIs by households. Banks fund the loans through a further $0.25 reduction in the reserves they hold. The size of banks’ balance sheet only goes down by $0.5, reflecting the reduction in households’ deposits.
  • At the end of this process, the Fed’s balance sheet shows a reduction of Treasury securities by $1 on the asset side, accompanied by a reduction in reserves by $0.75 and in ON RRP take-up by $0.25.

This example illustrates the potential for the Fed’s balance sheet reduction to affect several different markets and institutions. 

Conclusions

The actual evolution of private-sector balance sheets could involve adjustments similar to those outlined in the various scenarios described in our previous post on balance sheet runoff and in this one. These scenarios indicate that the adjustments in private-sector balance sheets can be quite complex, involving flows across markets and institutions that exceed the dollar value of the net increase in securities holdings by the private sector. Also, whether the adjustment on the Fed’s balance sheet happens through a reduction of reserves or of ON RRP investment depends on the type of securities that the Treasury issues (that is, whether MMFs can hold these securities), as well as on the relative return on different types of money market instruments.

Marco Cipriani

Marco Cipriani is an assistant vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.

James Clouse is a deputy director in the Division of Monetary Affairs at the Board of Governors of the Federal Reserve System.

Lorie Logan

Lorie Logan is an executive vice president in the Bank’s Markets Group.

Antoine Martin

Antoine Martin is a senior vice president in the Bank’s Research and Statistics Group.

Will Riordan is an assistant vice president in the Bank’s Markets Group.

How to cite this post:
Marco Cipriani, James Clouse, Lorie Logan, Antoine Martin, and Will Riordan, The Fed’s Balance Sheet Runoff: The Role of Levered NBFIs and Households,” Federal Reserve Bank of New York Liberty Street Economics, April 12, 2022, https://libertystreeteconomics.newyorkfed.org/2022/04/the-feds-balance-s....

Disclaimer
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

Overheating Conditions Indicate High Probability of a US Recession

Published by Anonymous (not verified) on Wed, 13/04/2022 - 11:55pm in

Larry Summers tells us a recession is coming....sometime....because the US is having too good a time job-wise.

Houston, We Have a Credit Problem

by Neil Tracey

In 2021, China had around 30 million homes sitting vacant for extended periods. There’s enough unused housing in China to house around 80 million people, roughly the population of Germany. This isn’t “slack” in the market; there is little hope that these homes will someday find an occupant. These homes are bound to remain empty.

Pile of credit cards

Our growth-obsessed economy requires credit to “succeed,” leaving millions in debt in a bloated economy. (CC BY 2.0, Sean MacEntee)

Indeed, most of these homes are simply held as financial assets; people who already own one home buy another and hang on to it, expecting it to appreciate. Even more peculiarly, Chinese property developers continue to build more homes. The absurdity of this market made headlines late last year with the story of Evergrande, a Chinese property developer that had accumulated over $350 billion in debt, then defaulted on large sums. Now, months after Evergrande first threatened to default, it has slipped from the headlines. However, it’s worth revisiting the story of Evergrande to understand just how it came to be. Why was a developer building more homes in a country that already had available housing for another 80 million people?

The answer lies in credit. Credit is driven by, and in turn reinforces, expectations for the future. By driving expectations for the future, credit steals democratic control over the future from citizens and gives it to market forces. We’ll explore this issue by looking at Houston, Texas and how the credit market drove its growth. Then we will address what credit may look like in a steady state economy and how steady-state economics may return control of their futures to citizens.

Extreme Growth and Houston: The “Limitless City”

Visiting Houston, one thing stands out: it’s a BIG city. With a population of over 5 million and a metropolitan area of over 9,000 square miles, Houston is the only American city without formal zoning restrictions. In his book, Ages of American Capitalism, Jonathan Levy explains that Houston is culturally, economically, and geographically defined by its cycle of credit-driven growth.

In Houston, there was an expectation that the city would expand. This expectation was the result of fomenting hysteria over oil, housing expansion, and pop culture. In their 1981 song Houston is Hot Tonight,  Iggy Pop sings, “Bright lights, Houston is hot tonight / Arabian sheiks and money, up in the sky / Now I don’t mind, a bloodbath / When I’ve got oil on my breath.” Combining exotifying imagery, money, and oil, Iggy Pop captures the overwhelming expectation of growth that seized Houston. This expectation of growth led to the expansion of cheap credit that let Houston expand so rapidly that its edges became undefinable. Urban geographers, trying to understand the limits of Houston, had to come up with a whole new set of terminology. Houston was a “multi-node city,” an “edge city,” an “edgeless city,” and a “boundless city.” Indeed, the only thing that seemed certain was that Houston was growing, and wouldn’t stop.

NASA satellite image of Houston, Texas lit up at night

Houston is certainly “hot tonight,” and getting hotter. (CC BY-NC 2.0, NASA’s Marshall Space Flight Center)

Houston’s role as a “limitless city” was due to credit. Credit is money or goods extended by a creditor to a recipient based on the understanding that the recipient will pay it back in the future, plus interest. Therefore, credit is a bet on the future ability of the recipient to pay back the money they borrow, and then some.

For this article, we’ll limit our discussion of credit to credit extended by a private creditor; in practice, that may be an individual, bank, or company seeking to make a profit (as opposed to a government agency advancing a social objective). Given this definition of credit, we can see how it may create a cycle of growth. Creditors decide to whom they should give credit based on who is likeliest to repay in the future. Creditors look to companies and individuals with historically high growth rates as a determining factor. In turn, having access to credit enables recipients to grow. A cyclical relationship between credit and growth ensues, whereby credit leads to growth, which leads to more credit, which leads to more growth, and so on.

This model of credit-driven growth can be seen in Houston, where growth expectations attracted the market for credit, since the promise of growth suggested that future property prices would increase. Thus, the expectation of growth meant that Houston applicants were perceived as “good bets” for repayment. This enabled the credit-fueled expansion of Houston as a business. At the same time, Houston’s expansion fueled the expectation that it would continue to expand. This expectation, then, fueled its expansion. Thus, the self-reinforcing mechanism of credit and growth expectations persisted.

At some point, this cycle of growth confronts the physical constraints of the natural world. After Hurricane Harvey dumped 51 inches of rain on Houston in 2017, the New York Times published: “A Storm Forces Houston, the Limitless City, to Consider Its Limits.” Since the flood, Houston has made little progress in considering those limits. Houston appointed a “flood czar” who wants to increase Houston’s green spaces to help absorb flood waters, but there’s no movement to limit the city’s growth. Only two years after Hurricane Harvey, the Houston City Council recklessly approved the development of a 100-year floodplain into condominiums.

Possibilities for Credit in a Steady State Economy

Due to this self-reinforcing cycle, the credit market is incompatible with a steady state economy. Ideas for how to reform this cycle come from a rather surprising source: John Maynard Keynes. Far from a steady stater, Keynes was famous for pitching the “propensity to consume” as well as government policies designed for growth. However, towards the end of his General Theory of Employment, Interest, and Money, Keynes presents some rather unique thoughts on the role of credit.

One idea for reform comes from the price regulation of credit. The price of credit (that is, the real interest rate) could be regulated to avoid unsustainable growth. The Federal Reserve already uses its power to set interest rates, and has long prioritized low rates to stimulate growth. However, the Fed could use a more nuanced approach to setting particular interest rates for loans in specific markets. There are certain areas of the economy that need credit to launch, such as the renewable energy sector. The Fed, with a little urging from Congress and the president, could set low interest rates for these sectors, essentially subsidizing them via differential interest rate. Outside of these sectors, the Fed would set higher interest rates to lessen the rate of growth in other sectors, and of GDP at large.

As a macroeconomic actor, the Fed wouldn’t be keen on dabbling with sectoral distinctions. If necessary, Congress could pass a bill to establish differential interest rates, if not directly via the Fed, then indirectly via fiscal policy such as credit supplements or taxes. Presumably such a law would have a sunset clause or be revisited and readjusted annually, as with an appropriations bill.

A related option is for credit to be socialized and overseen by a government agency. (While the quasi-governmental Fed exerts control over interest rates, most actual credit is extended through private banks.) Credit would be fully controlled, in other words, by democratic institutions.

Socializing credit would enable the government to marry its fiscal and monetary policies, extending credit to essential industries and limiting credit for increasingly outdated or harmful ones. However, for this proposal to work, the federal government would have to concurrently abolish the private credit system and limit access to foreign credit.

Portrait of Neil Tracey, CASSE's economic policy intern Spring 2022Neil Tracey is a junior at Georgetown University and an economic policy intern at CASSE.

The post Houston, We Have a Credit Problem appeared first on Center for the Advancement of the Steady State Economy.

Stagflation Threat: Be Pragmatic, Not Dogmatic

Published by Anonymous (not verified) on Thu, 24/03/2022 - 12:55am in

More discussion of the current, misguided central bank use of interest rates to combat inflation, and what will probably become stagflation.

Corporate Legacy Debt, Inflation, and the Efficacy of Monetary Policy

Published by Anonymous (not verified) on Mon, 21/03/2022 - 9:34pm in

Why high levels of corporate debt can make monetrary tightening less effective in controlling inflation.

Wherein I Try to Calm Professor Blanchard’s Nerves

Published by Anonymous (not verified) on Wed, 16/03/2022 - 11:24am in

Olivier Blanchard is rightly counted among the most eminent macroeconomists of our time, and his pronouncements on macroeconomic matters should not be dismissed casually. So his commentary yesterday for the Peterson Institute of International Economics, responding to a previous policy brief, by David Reifschneider and David Wilcox, arguing that the recent burst of inflation is likely to recede, bears close attention.

Blanchard does not reject the analysis of Reifschneider and Wilcox outright, but he argues that they overlook factors that could cause inflation to remain high unless policy makers take more aggressive action to bring inflation down than is recommended by Reifschneider and Wilcox. Rather than go through the details of Blanchard’s argument, I address the two primary concerns he identifies: (1) the potential for inflation expectations to become unanchored, as they were in the 1970s and early 1980s, by persistent high inflation, and (2) the potential inflationary implications of wage catchup after the erosion of real wages by the recent burst of inflation.

Unanchored Inflation Expectations and the Added Cost of a Delayed Response to Inflation

Blanchard cites a forthcoming book by Alan Blinder on soft and hard landings from inflation in which Blinder examines nine Fed tightening episodes in which tightening was the primary cause of a slowdown or a recession. Based on the historical record, Blinder is optimistic that the Fed can manage a soft landing if it needs to reduce inflation. Blanchard doesn’t share Blinder’s confidence.

[I]n most of the episodes Blinder has identified, the movements in inflation to which the Fed reacted were too small to be of direct relevance to the current situation, and the only comparable episode to today, if any, is the episode that ended with the Volcker disinflation of the early 1980s.

I find that a scary comparison. . . .

[I]t shows what happened when the Fed got seriously “behind the curve” in 1974–75. . . . It then took 8 years, from 1975 to 1983, to reduce inflation to 4 percent.

And I find Blanchard’s comparison of the 1975-1983 period with the current situation problematic. First, he ignores the fact that the 1975-1983 episode did not display a steady rate of inflation or a uniform increase in inflation from 1975 until Volcker finally tamed it by way of the brutal 1981-82 recession. As I’ve explained previously in posts on the 1970s and 1980s (here, here, and here), and in chapters 7 and 8 of my book Studies in the History of Monetary Theory the 1970s inflation was the product of a series of inflationary demand-side and supply-shocks and misguided policy responses by the Fed, guided by politically motivated misconceptions, with little comprehension of the consequences of its actions.

It would be unwise to assume that the Fed will never embark on a similar march of folly, but it would be at least as unwise to adopt a proposed policy on the assumption that the alternative to that policy would be a repetition of the earlier march. What commentary on the 1970s largely overlooks is that there was an enormous expansion of the US labor force in that period as baby boomers came of age and as women began seeking and finding employment in steadily increasing numbers. The labor-force participation rate in the 1950s and 1960s fluctuated between about 58% to about 60%, mirroring fluctuations in the unemployment rate. Between 1970 and 1980 the labor force participation rate rose from just over 60% to just over 64% even as the unemployment rate rose from about 5% to over 7%. The 1970s were not, for the most part, a period of stagflation, but a period of inflation and strong growth interrupted by one deep recession (1974-75) and bookended by two minor recessions (1969-70) and (1979-80). But the rising trend of unemployment during the decade was largely attributable not to stagnation but to a rapidly expanding labor force and a rising labor participation rate.

The rapid increase in inflation in 1973 was largely a policy-driven error of the Nixon/Burns collaboration to ensure Nixon’s reelection in 1972 without bothering to taper the stimulus in 1973 after full employment was restored just in time for Nixon’s 1972 re-election. The oil shock of 1973-74 would have justified allowing a transitory period of increased inflation to cushion the negative effect of the increase in energy prices and to dilute the real magnitude of the nominal increase in oil prices. But the combined effect of excess aggregate demand and a negative supply shock led to an exaggerated compensatory tightening of monetary policy that led to the unnecessarily deep and prolonged recession in 1974-75.

A strong recovery ensued after the recession which, not surprisingly, was associated with declining inflation that fell below 5% in 1976. However, owing to the historically high rate of unemployment, only partially attributable to the previous recession, the incoming Carter administration promoted expansionary fiscal and monetary policies, which Arthur Burns, hoping to be reappointed by Carter to another term as Fed Chairman, willingly implemented. Rather than continue on the downward inflationary trend inherited from the previous administration, inflation resumed its upward trend in 1977.

Burns’s hopes to be reappointed by Carter were disappointed, but his replacement G. William Miller made no effort to tighten monetary policy to reverse the upward trend in inflation. A second oil shock in 1979 associated with the Iranian Revolution and the taking of US hostages in Iran caused crude oil prices over the course in 1979 to more than double. Again, the appropriate monetary-policy response was not to tighten monetary policy but to accommodate the price increase without causing a recession.

However, by the time of the second oil shock in 1979, inflation was already in the high single digits. The second oil shock, combined with the disastrous effects of the controls on petroleum prices carried over from the Nixon administration, created a crisis atmosphere that allowed the Reagan administration, with the cooperation of Paul Volcker, to implement a radical Monetarist anti-inflation policy. The policy was based on the misguided presumption that keeping the rate of growth of some measure of the money stock below a 5% annual rate would cure inflation with little effect on the overall economy if it were credibly implemented.

Volcker’s reputation was such that it was thought by supporters of the policy that his commitment would be relied upon by the public, so that a smooth transition to a lower rate of inflation would follow, and any downturn would be mild and short-lived. But the result was an unexpectedly deep and long-lasting recession.

The recession was needlessly prolonged by the grave misunderstanding of the causal relationship between the monetary aggregates and macroeconomic performance that had been perpetrated by Milton Friedman’s anti-Keynesian Monetarist counterrevolution. After triggering the sharpest downturn of the postwar era, the Monetarist anti-inflation strategy adopted by Volcker was, in the summer of 1982, on the verge of causing a financial crisis before Volcker announced that the Fed would no longer try to target any of the monetary aggregates, an announcement that triggered an immediate stock-market boom and, within a few months, the start of an economic recovery.

Thus, Blanchard is wrong to compare our current situation to the entire 1975-1983 period. The current situation, rather, is similar to the situation in 1973, when an economy, in the late stages of a recovery with rising inflation, was subjected to a severe supply shock. The appropriate response to that supply shock was not to tighten monetary policy, but merely to draw down the monetary stimulus of the previous two years. However, the Fed, perhaps shamed by the excessive, and politically motivated, monetary expansion of the previous two years, overcompensated by tightening monetary policy to counter the combined inflationary impact of its own previous policy and the recent oil price increase, immediately triggering the sharpest downturn of the postwar era. That is the lesson to draw from the 1970s, and it’s a mistake that the Fed ought not repeat now.

The Catch-Up Problem: Are Rapidly Rising Wages a Ticking Time-Bomb

Blanchard is worried that, because price increases exceeded wage increases in 2021, causing real wages to fall in 2021, workers will rationally assume, and demand, that their nominal wages will rise in 2022 to compensate for the decline in real wages, thereby fueling a further increase in inflation. This is a familiar argument based on the famous short-run Phillips-Curve trade-off between inflation and unemployment. Reduced unemployment resulting from the real-wage reduction associated with inflation will cause inflation to increase.

This argument is problematic on at least two levels. First, it presumes that the Phillips Curve represents a structural relationship, when it is merely a reduced form, just as an observed relationship between the price of a commodity and sales of that commodity is a reduced form, not a demand curve. Inferences cannot be made from a reduced form about the effect of a price change, nor can inferences about the effect of inflation be made from the Phillips Curve.

But one needn’t resort to a somewhat sophisticated argument to see why Blanchard’s fears that wage catchup will lead to a further round of inflation are not well-grounded. Blanchard argues that business firms, having pocketed windfall profits from rising prices that have outpaced wage increases, will grant workers compensatory wage increases to restore workers’ real wages, while also increasing prices to compensate themselves for the increased wages that they have agreed to pay their workers.

I’m sorry, but with all due respect to Professor Blanchard, that argument makes no sense. Evidently, firms have generally enjoyed a windfall when market conditions allowed them to raise prices without raising wages. Why, if wages finally catch up to prices, will they raise prices again? Either firms can choose, at will, how much profit to make when they set prices or their prices are constrained by market forces. If Professor Blanchard believes that firms can simply choose how much profit they make when they set prices, then he seems to be subscribing to Senator Warren’s theory of inflation: that inflation is caused by corporate greed. If he believes that, in setting prices, firms are constrained by market forces, then the mere fact that market conditions allowed them to increase prices faster than wages rose in 2021 does not mean that, if market conditions cause wages to rise at a faster rate than they did in 2022, firms, after absorbing those wage increases, will automatically be able to maintain their elevated profit margins in 2022 by raising prices in 2022 correspondingly.

The market conditions facing firms in 2022 will be determined by, among other things, the monetary policy of the Fed. Whether firms are able to raise prices in 2022 as fast as wages rise in 2022 will depend on the monetary policy adopted by the Fed. If the Fed’s monetary policy aims at gradually slowing down the rate of increase in nominal GDP in 2022 from the 2021 rate of increase, firms overall will not easily be able to raise prices as fast as wages rise in 2022. But why should anyone expect that firms that enjoyed windfall profits from inflation in 2021 will be able to continue enjoying those elevated profits in perpetuity?

Professor Blanchard posits simple sectoral equations for the determination of the rate of wage increases and for the rate of price increases given the rate of wage increases. This sort of one-way causality is much too simplified and ignores the fundamental fact all prices and wages and expectations of future prices and wages are mutually determined in a simultaneous system. One can’t reason from a change in a single variable and extrapolate from that change how the rest of the system will adjust.

A Perfect Storm for Inflation: COVID, Loose Money, and Putin

by Brian Czech

The current bout of inflation should be no surprise to steady staters. We have national and global ecosystems pushed to the limits by population and economic growth. At the same time, we have monetary authorities and heads of state—neoclassically oblivious to limits—eager to stimulate the economy with loose money. It’s a recipe for inflation.

Gift of inflation.

A simple warning issued in March 2020: full tweet here.

We tweeted all the way back in March 2020 that inflation was coming. If it wasn’t already in the works from COVID-caused supply shocks, President Trump’s fiscal stimulus (CARES Act) put it there. President Biden’s American Rescue Plan came a year later (and one year ago today). These fiscal policies were politically prudent and remedial for many, but they fanned the flames for inflation.

And now we have a two-pronged supply shock emanating from the steppes of Eastern Europe. Russian energy and Ukrainian grain (plus Ukrainian energy and Russian grain) are now sanctioned, restricted, and constricted. The Russian threat also puts even more pressure on NATO countries and Russia to let loose with yet another round of money.

All this creates a perfect storm for an episode of inflation that will be long-lasting and global. If the war in Ukraine spirals further out of control for a protracted period, this inflationary period could become one of the worst in world history. It’s time to take a 21st century look at the fundamentals of inflation, and plan for the storm ahead.

Inflation

Inflation is one of those confounding concepts—a bit like gravity—that is at once easy to understand and subjected to baffling analysis. Fortunately, a perfectly clear and memorable phrase can be used to grasp it: “too much money chasing too few goods.” As such, you tend to know it when you see it. If you’re old enough to buy a beer, you’ve already seen plenty of it.

Three animated dollar bills chasing a runaway shopping cart full of goods.

Too much money chasing too few goods.

Economists distinguish “demand-pull” inflation from “cost-push” inflation. These are two sides of the same coin (so to speak), but the phrase “demand-pull” connotes the “too much money” aspect of inflation, while “cost-push” connotes “too few goods.” Yes, the distinction has a chicken-and-egg aspect: Given either pull or push, inflation is hatched.

Given that “too much money” and “too few goods” are aggregate measures, inflation is a macroeconomic phenomenon, but sometimes sectoral price increases are conflated with inflation per se. If everyone suddenly wants a pet rock, the price increases, but that’s not inflation, demand-pull or otherwise. Similarly, if rocks become harder to find, the price increases, but that’s not inflation, cost-push or otherwise. Consumers can turn to cheaper pet sticks or pet ants, or simply eschew the pet sector entirely. Prices don’t go up across the board. The price of pet rocks is simply a microeconomic phenomenon reflecting the supply and demand thereof.

It makes little sense, then, to talk of inflation exclusively in terms of pet rocks, widgets, or even lumber. It would seem that the proper way to measure inflation would be with a relatively full basket of goods, monitoring the cumulative price over time. That is, in fact, what the Bureau of Labor Statistics (BLS) does with the Consumer Price Index (CPI).

The BLS doesn’t need to include every single good and service stemming from the thousands of industries identified in the North America Industry Classification System. You might, for example, leave out the pet rocks. Surely, however, you wouldn’t want to omit groceries and gas, would you?

Yet that is precisely what economists at the Federal Reserve do with the curious concept of “core inflation,” which accounts for the prices of most goods and services except food and energy. For ecological economists, “core” sounds like a misnomer when the most essential goods are omitted. The rationale of economists at the Fed is that food and energy prices are more volatile than those of other goods; the core should be more stable. A less volatile core measure is supposed to make things easier for forecasting and goal-setting purposes, but it’s hard not to suspect some kind of political fish lurking in the waters circa 2000, when the Fed adopted the concept.

The notion of a non-volatile inflation metric is a bit like thinking, “When we weigh the patient, let’s not include the fat in the midsection, because that area jiggles around more than the rest of the body.” If it’s not a political red herring, the notion of a foodless, energy-absent core measure of inflation is yet another example of the conventional economics profession overlooking the primacy of the agricultural and energy sectors at the trophic base of the economy.

When you think about inflation, do you think it wise to omit grocery bills and gas prices? I didn’t think so. Neither would moms, car drivers, or eaters. (Have I left anyone out?)

Century of Supply Shock

In this article, “supply shock” takes on two meanings. We have the typical meaning of a sudden and steep decline in the supply of a resource, such as an oil shock resulting from an embargo. Of immediate concern, though, is the absolutely macroeconomic scenario I wrote about in Supply Shock: Economic Growth at the Crossroads and the Steady State Solution. A suite of essential resources are dwindling rapidly, although unobserved and out of mind for most. Soils, groundwater, sawtimber, fisheries, various minerals, and conventional energy resources become ever scarcer as the global population grows and the stocks of these resources are eroded, compromised, or outright liquidated. We’re entering an era or a century of Supply Shock, corresponding with other labeled periods such as the Anthropocene and Sixth Great Extinction.

Some may argue that, by definition, the ongoing, background declines of natural resources are trends, not shocks. That would be a fair argument if we were talking about one resource, but supply curves across the board are moving inward, and faster by the decade. Soon enough, the cumulative effect will be stunning to generations accustomed to dealing piecemeal with temporary supply issues, such as an oil embargo here or a fishery collapse there.

Furthermore, economists and politicians are still living in a fantasyland, expecting new technologies to save the day. By the nature of their professions, they tend to be older folks who’ve seen many a 20th century problem overcome with new technology. Unfortunately, most of them seem to have little sense that the low-hanging technological and thermodynamic fruits have been picked, leaving the shelves barer and less accessible for this century. The impending wake-up call will be quite a surprise to them, as it will be for the media who cover them.

For the broader public then, which in turn gets its fuzzy understanding of economics from the mainstream media, the combination of widespread shortages and the limitations of technology will suddenly appear overwhelming. People (exceedingly few of whom read outlets such as the Herald) will be wondering, “Why weren’t we hearing about this in advance?” They’ll be shocked.

In other words, while the economy of nature is undergoing its Sixth Great Extinction, the human economy is entering the Century of Supply Shock. The money supply will be chasing fewer goods, and the stage will be consistently set for inflation, just waiting for feckless fiscal and monetary actors.

Fiscal Stimulus

Biden launching the American Rescue Plan.

President Biden touting the American Rescue Plan. (CC BY-NC-ND 3.0, Eric Haynes)

Thus far we’ve had three rounds of economic impact payments—aka “stimulus checks”—to buffer the majority of American citizens from the economic impacts of COVID. Direct payments totaling approximately $867 billion have been or will yet be made pursuant to the CARES Act (2020), the Consolidated Appropriations Act (2020), and the American Rescue Plan (2021). $456 billion is somewhat attributable to Trump (who signed the first two bills), and $411 billion to Biden (who signed the American Rescue Plan). The total is not far from a trillion dollars; roughly five percent of American GDP and well over one percent of global GDP.

Where did such a huge sum of money come from? While it’s a little more complicated than this, the money is mostly debt. The CARES Act, for example, was signed by Trump on March 27, 2020, well into the fiscal year, which itself was budgeted for long before COVID-19 was even identified. In other words, the money came out of thin air, much like COVID.

That means we instantly had an inflated money supply, by definition, chasing goods already becoming scarce in the age of Supply Shock. Demand-pull and cost-push forces were already at work, with the depths of the COVID pandemic yet to come. The subsequent two fiscal stimuli packages were more planned and better budgeted, but still “financed” largely by debt, conducive to further inflation.

COVID-Caused Recession

The COVID-caused recession brings us back to the “fewer goods” part of the inflation equation. While COVID-19 triggered an initial wave of positive demand shocks for such home-bound supplies as toilet paper, pasta, and paper towels, negative demand shocks slammed the hospitality, entertainment, and certain retail industries. (Imagine being an airline or a dentist during the depths of the pandemic.)


Sports and entertainment sectors took a heavy hit during the COVID pandemic.

More importantly, virtually all sectors were slowed by supply chain issues resulting from workplace shutdowns and an erosion of the labor force due to covid deaths, illness, and exposure avoidance. The ultimate avoidance tactic was retirement or resignation. Millions of workers—especially the very young and the retirement-eligible—learned they didn’t necessarily need to work. Not when they were receiving stimulus checks while saving the expenses of commuting and parking. The Great Resignation is “still in full swing,” too.

Only higher-income individuals and families weren’t eligible for stimulus checks. That means those who received the checks were fairly dependent upon them for essential goods and basic services; the checks weren’t deposited in savings accounts. The demand for such goods (most notably food) is price-inelastic, too, so the sudden glut of debt-based money was bound to settle into the prices at grocery stores, convenience stores, and pharmacies. That’s demand-pull inflation.

As if all that wasn’t enough, Russian President Vladimir Putin ordered the invasion of Ukraine on February 24, 2022, setting in motion supply shocks at the trophic base of the economy.

The Volatile Mix of Gas and Grain

The relevance of trophic levels in the structure of the economy is about to take center stage in the tragic play called Inflation 2022. Almost one-fourth of the world’s wheat and nearly a third of its barley comes (normally) from the grain belt stretching from western Ukraine through southwestern Russia. Ukraine alone provides about 16 percent of the world’s corn. Significant shares of rye, soybeans, potatoes, vegetable oils (most notably sunflower), and numerous other food staples emanate from this breadbasket of Europe.

Ukrainian agricultural production and transport will be severely challenged by the Russian invasion. The vast majority of wheat in this part of the world is winter wheat; planted in fall and harvested in summer. If the war remains hot into the summer, with most Ukrainian men—and many women as well—occupied with fighting, farming will suffer. Farmers are also facing shortages (high prices) of fertilizers and pesticides at a time when income flows and even basic financial operations will be difficult to maintain. Similar problems will be faced in all of the major Ukrainian agricultural operations. For what surplus might remain, export routes along the Black Sea are cut off.

In addition, Russian commodity exports have been banned, not only by receiving countries but, in retaliation, by Putin himself. That means grain from the USA and Canada, along with lesser grain belts in Mexico, Argentina, Chile, Brazil, China, India, Australia, Kazakhstan, and Turkey will be needed to feed the world. Wheat and corn prices are already skyrocketing, and supply shocks from the “chernozem” belt of Ukraine/Russia are reverberating into the price points for all cereal grains including rice.

Meanwhile, as steady staters know, money originates from the agricultural surplus that frees the hands for the division of labor unto all other sectors. That’s the trophic theory of money, which links the real (trophically structured) economy with the monetary sector in a manner that makes inflation easier to understand. The trophic theory of money implies that, if agricultural surplus declines, less real money is “authorized.” When the agricultural decline is sudden, as with a pronounced, cereal grain supply shock, the nominal money supply is just as suddenly inflated. And this is precisely the current situation.

In other words, no one should be wishfully thinking that inflation can be confined to the grocery store. All the money in the world—real money that is, adjusted for inflation—stems from agricultural surplus (or more generally, food surplus, which at this point in history is all about cereal grains). This underscores the truly macroeconomic aspect of inflation. It’s not only market forces that reallocate demand into different sectors, spreading price increases along the way. Rather, the money supply—same supply used for all goods and services—is inflated from the moment the agricultural surplus declines. If it takes a little longer for prices of some goods and services to increase, relative to others, the difference can be chalked up to the trophic procession of production from agro/extractive at the base to heavy manufacturing (and rough services) in the middle to light manufacturing (and refined services) at the higher levels. That’s why, in these early stages of the Russian invasion, commodity prices have increased faster than others.

Of course, one such commodity is energy; most notably crude oil and natural gas, supplies of which have also and suddenly been disrupted by the war. These are probably the most widely reported commodities for several important economic, environmental, and geopolitical reasons. I bring them up here primarily to highlight their linkage to agricultural production. Cereal grain production in the chernozem belt has become heavily mechanized, and the trend continues. As if all the other hurdles weren’t enough for Ukraine and Russian grain production and export, rapidly rising fuel prices add further to the cost-push inflationary pressures.

As global leaders, think tanks, and corporations analyze or plan for the future, they may want to pay close attention to the economic effects of the war in Ukraine. We’re learning a painful lesson about how disastrous things can become when we push beyond reason for growth. The planet can only produce so much food, oil, natural gas, and all the other resources. Yes, renewables are coming online for powering electricity grids, but the wheat combines of the Eurasian steppe don’t turn on a dime, and renewables may never cut it for the type of sheer horsepower needed for cultivating the chernozem of Eurasia, North America, or any other grain belt.

The money supply, on the other hand, can become inflated overnight, impacting the lives of billions of people in short order and with long-lasting consequences for families and businesses.

The warning signs are clear now, and they’re not all about the environment. The biggest, newest red flag on the planet is inflation, the dreaded tax-in-effect that hits everyone, everywhere. In the Century of Supply Shock, inflation will always be nipping at our heels, ready to run wild with any agricultural supply shock, ready to run loose with any feckless “stimulus,” fiscal or monetary. It’s yet another warning that we need a new approach: degrowth toward a steady state economy.

Brian Czech, Executive Director of CASSEBrian Czech is the executive director at CASSE.

The post A Perfect Storm for Inflation: COVID, Loose Money, and Putin appeared first on Center for the Advancement of the Steady State Economy.

Inflation Targeting Constrains Development

Published by Anonymous (not verified) on Wed, 09/03/2022 - 9:55pm in

The rich have influenced most developing countries to prioritize inflation targeting in monetary policy instead of adopting bolder economic policies for growth, jobs and sustainable development.

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