Over at Greg Mankiw’s blog, a discussion of whether the “surging monetary base” necessarily means inflation down the road:
Both reserves and T-bills are interest-paying obligations of the Federal government (including the Federal Reserve). They are essentially perfect substitutes. The monetary base, however, includes one of them but not the other, largely for historical reasons.
The bottom line is that when reserves pay interest, the monetary base is a pretty uninteresting economic statistic.
Does this mean that investors should stop worrying about inflation? No. Yet the worry should stem not from the monetary base but from the political economy and difficult tradeoffs facing monetary policymakers. As the economy recovers, interest rates will likely need to rise. Will the Bernanke Fed, feeling the political heat, get behind the curve and allow inflation to take off? Will it decide that a little bit of inflation is not so bad compared with the alternative of risking an anemic recovery, a double dip recession, or (gasp!) congressional action to reduce Fed independence? Maybe. This is, I think, the right way to argue that higher future inflation is a plausible outcome.
I don’t know whether such inflation worries are justified. But I am pretty sure that the exploding monetary base is not, by itself, a reason to fear a coming surge in inflation.
Mankiw remarks on a WSJ article a few days ago talking about some large investors betting on a rise in inflation and citing the the rise in the monetary base. My own view is that these investors are perfectly aware of this, but are, in fact, making a political macro-bet that policy-makers will not have the political will to restrain inflation. It would not surprise me in the least if it were the bet Soros ultimately makes – many, perhaps even most, of his biggest plays over the years have come by making political bets on the failure of immediate political will, starting with his bet twenty years ago against the pound.
Let me ask our readers a lightly different question. How good are inflation-indexed USG debt as a hedge against inflation? A prominent commentator – Martin Feldstein, I believe – suggested a few days ago that for many retail investors, they were a much better inflation hedge than gold. (Someone might be good enough to send me the link.) What is your view, both on the inflation outlook and on inflation hedges for the retail investor?
Jon says:
Indexed USG debt is not a hedge against inflation. Its a speculative transaction on a future government report—the BLS Consumer Price Index.
For many reasons the BLS report does not capture inflation as people experience it.
One of the best hedges against unexpected inflation is… stock ownership. Future revenues of a company grow with inflation and consequently so does the stock-price.
December 29, 2009, 4:56 pmMark N. says:
The definition of “money supply” at all, as something distinct from non-money assets, seems to be getting increasingly fuzzy. In the modern era of electronic accounting and instant, electronic asset transfers, a lot of things are quasi-money, really: anything whose “ownership” can be easily moved from one fellow’s electronic column to another’s, in settlement of debts, can function as money.
I’ve vaguely heard of attempts to replace the clasic definition of “money supply”, based on categorizing asset classes into money/not-money, with one that’s more empirically grounded in an analysis of actual transactions. Anyone know anything about work of that sort?
December 29, 2009, 5:05 pmAlan Gunn says:
Stocks have not been a good hedge against inflation; in past inflationary periods (1970s, for instance) they did poorly. Feldstein’s data show gold doing very poorly, too; gold is perhaps best thought of as a hedge against complete collapse of the government. While the CPI isn’t a perfect measure of inflation, as it tends to overestimate it, it’s better than anything else I know of. So TIPS and their equivalents look good to me.
December 29, 2009, 5:09 pmJaimeInTexas (Jam) says:
Fiat currency is money “backed up” by all the production and services of the economy. If currency is printed in excess of the “production” it means that there is more money per unit of production and, therefore, the imputed “value” of an unit is higher.
At my level, single income household, fairly fixed income, we have been experiencing first hand tha loss of purchasing power. No matter what chages we keep making, it is never enough.
Yeah, there is a montery inflation bomb coming.
“But I am pretty sure that the exploding monetary base is not, by itself, a reason to fear a coming surge in inflation.”
Only if you are at a level of income that allows you to invest to cover, at lest, the loss of purchasing power.
December 29, 2009, 5:21 pmJohnF says:
The Feldstein article is here.
Basically, if the amount of stuff that can be used to buy things, e.g., money, which is held by purchasers of things, increases faster than the amount of things that can be bought, the price of the things being bought will rise. The problem is in defining what can be used to buy things, who are the relevant holders, and what is the stuff that can be bought. Mankiw’s point is just that bank reserves, like treasuries, are not used to buy things.
December 29, 2009, 5:31 pmA. Zarkov says:
“How good are inflation-indexed USG debt as a hedge against inflation?”
TIPS are not very good unless held in a tax-free account such as an IRA. The principle is increased pro-rata with increases in the CPI. But the increase in principle is taxed every year you hold the TIP– the so-called “imputed income.” Income you don’t realize but you are taxed on anyway. Much better are iBonds where the interest rate is indexed and you don’t pay any taxes until you redeem the bond. BUT currently Treasury won’t let you buy more than $5,000 total. I loaded up on iBonds when the core rate was very high and you could buy lots of them. I got a very good deal and they will provide me with some hedge. Of course as already pointed out the CPI understates the cost of living for a variety of reasons. See shadowstats.
Stocks did not do well in the 1970s a period of high inflation. Except for gold stocks which did well during the Great Depression too. I own gold stocks. In my opinion, at this point, commodities will be the best hedge against inflation. I would buy something that tracks the Rogers index.
December 29, 2009, 5:40 pmA. Zarkov says:
Mankiw writes,
He skirting the main issue. The Fed has a lot junk on it’s balance sheet– perhaps a $ trillion of more. The Fed won’t say what they have and who they bought it from, and that should make you very very nervous. Who will buy this junk when it comes time to get it off the Fed’s balance sheet?
December 29, 2009, 5:46 pmA. Zarkov says:
If you want something more substantive about the reserve issue read this. Mankiw’s discussion is largely useless if not dead wrong.
December 29, 2009, 5:50 pmscattergood says:
JohnF and A. Zarkov have hit the nail on the head. JohnF’s point that inflation is about the PURCHASING POWER of 1 USD and not the amount of dollars in the system. And a. Zarkov very rightly points out that the taxation on inflation related instruments seriously impacts their usefulness.
I would like to add however, that the inflation risk right now has to do with the velocity of money. The standard econ equation is:
MV = PQ where:
M = Money in circulation
V = Velocity or turnover of that money
P = Price
Q = Quantity of goods and services sold
The problem we have now is that during the ‘crash’ V sunk a ton and M started to sink, but the Gov’t stepped in at various parts of the economy (cash for clunkers, TARP, discount window, Quantitative Easing, etc.) and pumped M back up.
However, V, or the rate of transactions hasn’t picked up yet. So it is like stuffing a fireplace with tons of small pieces of paper and saying, ‘well when it STARTS burning, we’ll take some of the paper away’. If and when V starts moving, (lots of cars being sold, houses changing hands, people going on lots of trips, buying lots of stuff, etc.) it wil be predicated on the banks loaning it out. And there is a TON of reserve cash to prime that inflationary pump.
On the other side the banks who are sitting on the cash are saying, ‘well we have a ton of losses coming our way, we don’t want to loan it out because we have to protect our balance sheet’, and the consumer is saying ‘well, we don’t want to borrow we want to save and pay back our debts’.
The Gov’t has basically said, ‘if you the US consumer won’t borrow and spend, we will do it for you’ in order to keep prices ‘high’. This is the inflation vs. deflation battle that is going on.
My vote long term is deflation, but we MAY have a spurt of inflation in the next 5 years. Either way, TIPS are a reasonable inflationary hedge, but in tax free accounts preferably.
December 29, 2009, 5:57 pmJon says:
Its well established that CPI understates inflation–largely due to methodological changes introduced during the early 90s. The TIPS market is too thin regardless. TIPS are overbought and thus necessarily yield poorly. Only use TIPS to hedge exposures directly tied to CPI. They are too obscure/specialized for the typical retail investor.
December 29, 2009, 6:05 pmJon says:
No. We know the nature of the junk. Its Freddie/Fannie securities. The problem is not with the quality. Its that most of the paper is of recent vintage and carries a very low interest-rate. Once long-dated market interest-rates rise (because of inflation expectations), it will be impossible for the Fed to recover par-value for the paper. This has nothing to do with the “junkiness” of the paper.
This is somewhat unprecendented. It’s this uncertainty that is cause for concern.
December 29, 2009, 6:36 pmJon says:
This remark is pretty much nonsense. The substitution of reserves and t-bills have very little to do with the conduct of monetary policy (shockingly most economists don’t know even the rudiments of how monetary policy is implemented–they are fixed on a toy academic model that does not describe the US).
Reserves matter because they interact with the reserve requirement. By far the easiest method of sterilizing the reserves is to raise the reserve requirement. That this isn’t being mentioned as a fallback, demonstrates that the Fed is not serious about containing the beast.
Government debt matters because it can be discounted by banks without interacting with capital requirements.
December 29, 2009, 6:42 pmJaimeInTexas (Jam) says:
Mish thinks that printing money is capital!
If banks are only capital constrained and they get a bunch of freshly printed bills but expect a bunch of mortgages/loans to be paid, they have to hold to the “new capital.”
In unison, monetizing debt.
December 29, 2009, 6:50 pmlgm says:
Yes, there are people betting in high near term inflation. But the market as a whole is making the opposite bet — long term inflation control. The Treasury yield curve is the effective interest rate on a hypothetical US Treasury bond that pays only a lump sum after 30 years (and nothing in between — a “zero coupon” treasury). It is set in the market by investors worldwide. Today, the 30 year Treasury yield is 4.64%. Assuming inflation of 3%, this is a 1.64% real yield. Pretty low as a compensation for having money locked up for 30 years.
Maybe this is a “bubble” in that one day the market will wake up and send Treasury yields way up. But it doesn’t look that way today.
December 29, 2009, 7:05 pmA. Zarkov says:
You’re right, but only partly. My understanding is the Fed has allowed banks to give them their CDOs and other hard to price instruments in exchange for base money.
December 29, 2009, 7:43 pmAllan Walstad says:
Question: Can anybody tell me where the Fed is getting the money to pay interest, and how much that is adding up to?
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December 29, 2009, 10:46 pmAlan Gunn says:
Claims that the current version of the CPI understates cost-of-living increases seem to me to be based on a belief that the older “basket of goods” measure was right. It wasn’t. If people who worry about inflation are concerned with maintaining their current standard of living, today’s CPI isn’t bad. One can, of course, argue that the baseline ought to be not maintaining one’s current standard of living but increasing one’s standard of living by whatever rate the economy is growing; if you take that as the norm, you can make a case that the CPI understates increases in the cost of living. I suppose one’s choice between these would depend in large part on one’s age: old folks (like me) might tend to be content with maintaining their current standard of living, but young people would expect their standard of living to at least keep up with growth in the economy.
Technically, to be sure, an index designed to measure inflation itself (rather than cost-of-living increases) would match the older version of the CPI more closely that the newer one, so it’s true that today’s CPI does underestimate inflation.
December 30, 2009, 9:46 amJaimeInTexas (Jam) says:
I took a tour of the FRB, Houston, with a group of students. The FRB fellow (sorry, I forgot his name) who gave the talk about the FRB, the economy, etc., and I had a conversation which included the CPI.
“today’s CPI isn’t bad.” Oh, yes it is.
If the “basket of goods” is adjusted to account for people buying more hamburger (ground) meat because steaks cannot be afforded, that IS a loss of standard/quality of living. It is a quantitative loss measurable only if you remember the previous formula. And it is to the advantage of the FRB and politcians to discourage memory.
It is 1984!
December 30, 2009, 11:10 amAlan Gunn says:
If that were what they do, it would indeed be a bad thing. But it isn’t. (The quote is from a site that basically bashes the CPI, not “JamieInTexas’s own words.) The kind of adjustment they make is illustrated by tires. The old CPI assumed that if a tire today costs 10 times what a tire cost 40 years ago, that meant a tenfold increase in the cost of living. The adjustment they now make takes account of the fact that a modern tire lasts maybe five times as long as the ones that we had 40 years ago. So they’re measuring what a mile of tire use costs, not the meaningless “cost of a tire.” Whether the change is an improvement or not depends on what you’re trying to measure. The government does engage in a lot of downright fraudulent practices (Social Security “trust fund,” for instance). But this isn’t one of them.
December 30, 2009, 12:59 pmAllan Walstad says:
Let me see if I’ve got this straight. When the housing bubble burst, banks were left insolvent because they couldn’t collect on many of the loans, whether securitized or what. So the Fed stepped in and gave them a bunch of money as “reserves.” If the money starts getting lent out into the economy, it will fuel “inflation”, i.e., a rise in prices. So the Fed can pay interest on the reserves to encourage banks to keep them in place. If at some point it becomes feasible to reduce those reserves by turning them into federal T-bills, then the danger of high inflation will have been averted.
But by issuing T-bills, the Fed has increased the national debt, hasn’t it? So in effect, the Fed will have just done what Congress could have, namely, take money from taxpayers in the short or long term and give it to the banks. Except that the pols themselves didn’t have to put their necks on the line for it. Is that what makes Bernanke such a genius?
December 30, 2009, 1:06 pmJon says:
One of the significant problems with the current CPI approach is geometric weighting. That approach has no physical justification. Its value lies solely in that it leads to computing a lower rate of inflation.
You are thinking of hedonics. Yes, hedonics done right is superior to a naive basket of complex goods.
December 30, 2009, 4:27 pmA. Zarkov says:
I spoke with a statistician at BLS and we talked about the shift from the arithmetic mean to the geometric mean. He said that was done to correct for the substitution effect. When prices go up people switch to cheaper items such as hamburger instead of steak. I don’t understand his argument at all. One uses the geometric mean when it makes sense to operate in log space– when quantities have a lognormal distribution. The lognormal has some nasty properties like not being determined by its moments and not having a characteristic function (Fourier transform). I put this issue on a back burner, perhaps its time to revisit.
December 30, 2009, 5:07 pmThales says:
Allan Walstad: I don’t believe the Fed “issues” T-Bills–rather it buys or sells existing ones issued by the Treasury; these are Fed open market operations. So while it uses such operations to influence short term interest rates, the national debt neither increases nor decreases as a result of Fed action–do I have this wrong?
December 30, 2009, 6:21 pmMichael F. Martin says:
TIPS seem like a good deal for individual investors close to retirement. For youngsters like me, the better bet in an inflationary environment are the high-quality brands that will suffer less from elasticity in demand within their markets as prices go up.
Some of this kind of thinking is already priced into some stocks. What I predict for 2010 is a market pullback approximating 2008, but with a differential impact on companies demanding on the relative price elasticity of demand for their goods among competitors.
Incidentally, I believe the inflation risk is also why you see so many of these name brands vertically integrating supply and distribution chains over the past few months. Any holdups in the chain can cut into the bottom line in an inflationary environment.
December 30, 2009, 6:23 pmJaimeInTexas (Jam) says:
Excuse me? Those were my words. If someone else have used similar words is purely coincidental. What I wrote reflects an actual conversation I had with an FRB official, a few years ago, when I was one of the adults who took a group of homeschoolers in a tour of the Houston’s Branch of the FRB.
December 30, 2009, 6:58 pmJaimeInTexas (Jam) says:
But if the “basket of goods” is adjusted because people have to buy tires of a lesser quality because they cannot afford the quality they normally would buy, that is a loss in quality of living. And, unless folks understand that the CPI calculation has changed when the CPI may not even reflect a numerical change. Same as in the ground/steak example.
The tire example, if in constant dollars reflect a lowering of the cost on a per mile basis, is what some people call price deflation and is supposed to be a baaaad thing. And using the cost of the tire is not meaningless. A tire that lasts longer means that it is purchased with a lesser frequency. I presume that a formula that uses the cost of an item also accounts for its expected lifespan.
December 30, 2009, 7:19 pmMichael F. Martin says:
I don’t intend to intervene in this discussion of the change in CPI calculation — which is interesting.
But I want to point out that any assumption that an economic formula takes into account the frequency of consumption is likely to be wrong. The problem is that historical economic data tends to be aggregated such that one gets a steady-state time-average rather than a sample of the different frequency components.
Accounting standards also generally do not require frequency information to be reported, but only time-averaged sales and costs of sales with snapshot of the balance sheet.
December 30, 2009, 7:33 pmAllan Walstad says:
Thales,
December 30, 2009, 8:17 pmI can understand that the Fed buys T-bills already out there. But where does it come up with the ones it sells? Yes of course, it has ones that it previously bought in the open market, but now we are talking about hundreds of billions of bucks’ worth. Are they really just sitting on that many, that they purchased earlier?