Monday, May 16, 2011

Money and Inflation

Milton Friedman told us that "inflation is always and everywhere a monetary phenomenon," but that statement is so loose that it can only be suggestive. What is money anyway? If we know what money is, can observing its behavior help us predict inflation? If we have more or less inflation than we would like, do time series observations on the stock of money help us to get us where we want to go?

Among Old Monetarists (or quantity theorists), led by Friedman, the standard view was that money should include all media of exchange (more or less), and that the key factor guiding our choice of an appropriate monetary aggregate be the existence of a stable, parsimonius demand function for that monetary aggregate. Friedman argued in his 1968 AEA Presidential address, that central banks should target the growth rate in some monetary aggregate. Note that he also argued that targeting the price level would be a bad idea, as it would lead to instability. Current conventional wisdom appears to be just the opposite. Central banks that jumped on the money-targeting bandwagon in the 1970s and 1980s subsequently jumped off, and some of them adopted explicit inflation targets.

Modern central banking (under normal circumstances) typically amounts to setting some target for an overnight interest rate, with the central bank intervening over the very short run (a few weeks) to hit that target. Decisions about changes in the target are made based on recent inflation experience, recent real economic activity (particularly in the US, where there is an explicit "dual mandate"), and forecasts. This operating procedure appears to work well, in part due to substantial instability in the demand for means of payment at the retail level and among financial institutions.

How does a New Monetarist think about money and inflation? Certainly inflation is always and everywhere a monetary phenomenon. The prices of goods and services, and the full array of asset prices and interest rates, are the terms on which we collectively hold the existing stocks of assets. The quantities of assets used extensively in transactions involving goods and services must have primary influence on the prices of goods and services. However, attempting to add up some asset quantities, calling the total "money," and then attaching some significance to that total, seems like a pointless exercise. For example, an Old Monetarist might add currency and reserves together and call the total "outside money," but of course most of the $1.5 trillion in reserves now outstanding in the United States just sit overnight, and are not used in transactions of any sort. Indeed, US Treasury bills currently have a greater claim to membership in the "money" club, as they are much more useful in financial transactions than are reserves, at the margin.

For a New Monetarist, the most fruitful way to think about a central bank (as might be obvious) is as a financial intermediary. Central banking then must matter to the extent that the central bank has some specific advantages relative to private financial intermediaries. These advantages stem from the central bank's monopoly over currency issue, and its payment system monopoly, whereby reserve accounts are the primary vehicle for settling debts among financial institutions. Under current circumstances, it is the stock of currency that matters, and reserves matter to the extent that they are convertible one-for-one into currency. Currency can be withdrawn by a financial institution from its reserve account just as you withdraw cash from your checking account at the ATM.

As I argued here and here, open market operations by the Fed in US Treasury debt are currently essentially irrelevant. When the Fed is holding a positive stock of excess reserves, and paying interest on those reserves, it should be obvious that traditional swaps of reserves for T-bills have no effect. There is essentially a liquidity trap, no matter what the interest rate on reserves (IROR) is. What is not so obvious is that this also applies to swaps of reserves for long-maturity Treasury securities, since the Fed is no better at transforming long Treasuries into overnight liabilities than is the private sector.

Thus, the $1.5 trillion in reserves currently outstanding in the US do not represent any more of an inflation threat than if the Fed were holding $1.5 trillion less in assets and excess reserves were zero. However, if the Fed continues to hold the IROR at 0.25%, the stock of currency can grow in a purely passive fashion to produce more inflation. That is, suppose that financial institutions perceive that the nominal returns from assets other than reserves are higher. When reserves become relatively less attractive, holding constant the total quantity of Fed liabilities, the composition of those liabilities must change, i.e. ultimately there must be less reserves and more currency. Part of the adjustment can occur through an increase in the price level. If the quantity of excess reserves were zero, the perception of higher nominal asset returns on the part of financial institutions would imply that the Fed would have to engage in open market purchases in order to maintain its fed funds rate target, and these open market purchases would be reflected in a larger stock of currency. Thus, the only difference between what happens with positive excess reserves and zero excess reserves is that, with positive excess reserves the overnight interest rate is fixed and the quantity of currency adjusts passively, and with zero excess reserves the quantity of currency is fixed and the overnight interest rate adjusts passively.

Thus, the stock of currency seems important for the determination of the price level, but what do we know about the demand for US currency? The first chart shows the ratio of currency (the currency component of M1) to nominal GDP, since 1947. The chart shows that the currency/gdp ratio fell from above 11% in 1947 to a low of 3.8% in the early 1980s, then rose. There was a substantial decrease before the financial crisis, to about 5.3%, but the currency/GDP ratio is currently at 6.2%, a level last seen in 1960.

Now, in light of the popular view that the demise of currency is imminent, these numbers might be surprising. I wrote about this earlier here, in the days when looming deflation seemed to be the big worry. In the case of US currency, much is held overseas. How much? As a comparison, currency held in Canada is 3.4% of Canadian GDP, so possibly about half of the stock of US currency is held abroad. If that were the case, that still implies that the quantity of currency held within US borders is more than $1500 per US resident. That's a lot of cash, and a significant fraction (how much I have no idea) is being used in nefarious activities.

Thus, the stock of US currency outstanding is large, and it has become larger since the onset of the financial crisis. Yet due to the nature of currency, and the role of US currency as an international medium of exchange, we cannot quantify the demand for US currency, or forecast it. Further, under current circumstances the Fed does not directly control the quantity of currency in circulation, but can control it indirectly, through the IROR.

What has been happening to the stock of currency recently? The next chart shows year-over-year percentage growth rates in currency (blue), the headline CPI (red), and core CPI (green). Year-over-year growth in currency has been increasing for the last year and now exceeds 8%.

Now, it is hard to see how the demand for US currency in the world is likely to increase further, in real terms. Whatever was driving the increase in currency demand in the financial crisis will likely reverse itself, so if US real GDP grows at 2-4% this year, and currency growth is at 8% per year and increasing, it seems the lower bound on the inflation rate in the near term is about 4%. Here, Ben Bernanke tells us:
FOMC participants see inflation remaining low; most project that overall inflation will be about 1-1/4 to 1-3/4 percent this year and in the range of 1 to 2 percent next year and in 2013. Private-sector forecasters generally also anticipate subdued inflation over the next few years.
Now, maybe FOMC participants know something about future tightening that they are not telling us, but this forecast seems well on the low side given the FOMC's stated goal of keeping the IROR at 0.25% for an "extended period."

Bernanke and company would like us to ignore the increase in headline inflation that we have seen, but money does not discriminate between goods and services that are in the "core" and those that are not. If money is growing at a rate that seems in excess of what is consistent with 2% inflation, and the demand for the stuff is not increasing in real terms, then headline inflation has to exceed 2%, and it's not going to be temporarily high if money growth is sustained at that level. It's not crazy to think that the Fed should be tightening in the fall, if not earlier.

32 comments:

  1. "As I argued here and here, open market operations by the Fed in US Treasury debt are currently essentially irrelevant. When the Fed is holding a positive stock of excess reserves, and paying interest on those reserves, it should be obvious that traditional swaps of reserves for T-bills have no effect. There is essentially a liquidity trap, no matter what the interest rate on reserves (IROR) is. What is not so obvious is that this also applies to swaps of reserves for long-maturity Treasury securities, since the Fed is no better at transforming long Treasuries into overnight liabilities than is the private sector."

    Why didn't you find Andy Hareless's reply to this in comments persuasive?

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  2. the Fed is not a mark-to-market investor. that would seem to (me to) be the key difference between it and the private sector that you fail to mention.

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  3. Richard,

    Because he wasn't persuasive.

    Anonymous,

    Irrelevant.

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  4. "However, attempting to add up some asset quantities, calling the total "money," and then attaching some significance to that total, seems like a pointless exercise. For example, an Old Monetarist might add currency and reserves together and call the total "outside money," but of course most of the $1.5 trillion in reserves now outstanding in the United States just sit overnight, and are not used in transactions of any sort."

    Yep, couldn't agree more. Money-counting is futile, in the same way that trying to sum up all the goods in the economy that are pretty would be futile.

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  5. "However, if the Fed continues to hold the IROR at 0.25%, the stock of currency can grow in a purely passive fashion to produce more inflation. That is, suppose that financial institutions perceive that the nominal returns from assets other than reserves are higher. When reserves become relatively less attractive, holding constant the total quantity of Fed liabilities, the composition of those liabilities must change, i.e. ultimately there must be less reserves and more currency."

    This seems to me to be saying that, should banks desire to make large purchases of assets yielding more than the IOR, they'll turn their reserves into paper dollars in order to transact. But no one pays for $300 million worth of GOOG with cash. They'll just wire their reserves to the selling bank... voila, no net increase in cash and no net decrease in reserves, the composition of Fed liabilities stays the same. And the GOOG shares have changed ownership.

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  6. So why are TIPS still at only a 2.4% spread? The Cleveland Fed corrections show 10 year expected inflation even lower, at 1.86%. (http://www.clevelandfed.org/research/data/inflation_expectations/index.cfm?DCS.nav=Local)

    I mentioned this at a conference last week, and I was told that TIPS investors have bimodal expectations. But why? And doesn't that mean that a lot of people are expecting zero inflation or deflation?

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  7. why is the lack of MTM constraint irrelevant? most investors don't have the backstop of the american taxpayer (ultimately) behind them (though one can argue the TBTF banks do).

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  8. a couple of follow-up questions:
    1) "Whatever was driving the increase in currency demand in the financial crisis will likely reverse itself" --- if you don't know what was driving money demand, how do you know it will reverse?!
    2) how are you relating currency growth to inflation rates (or lower bounds thereon)?

    thanks.

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  9. Why focus solely on the stock of currency? If actors demand more currency for transactional purposes, then they should also hold higher demand deposit balances. This would show up as M1 growth. In other words, the composition of constant Fed liabilities includes Excess Reserves, Required Reserves, and Currency.

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  10. Not sure I get it. You start by saying that looking at monetary aggregates is not helpful, and you end by looking at one particular aggregate, which is currency.

    Is the takeaway that the essential difference between old and new monetarist insofar as policy recommendations is that we should focus our attention not on "broad" money but on "narrow" money?

    -RV

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  11. JP,

    No, of course financial institutions are not transacting with currency. The idea is that asset prices and the prices of goods and services have to adjust so that all of the assets are willingly held. If something exogenous changes that makes reserves less desirable to hold, then if the Fed does not change the IROR (which is determining short rates), something else has to change. I'm saying that it's the price level that will absorb the brunt of the shock.

    David,

    Yes, apparently the markets take the Fed at its word, and they believe it will ultimately tighten as needed to keep inflation under control. I'm suggesting that the time may be upon us when they need to do that.

    anonymous mtm,

    Yes, the Fed will never default, as ultimately the taxpayers pick up the tab. I'm saying the Fed and the Treasury collectively are no better at helping us bear the maturity risk than is the private sector.

    anonymous reversal,

    Yes, I did contradict myself somewhat there. Based on timing, I think we can say something about where some of the demand for currency is coming from. Clearly it increased during the financial crisis, and it seems that increase has to be temporary. Further, I don't know of anything that would tell us to expect further increases in the demand for US currency in the world. I think it has to be going in the other direction, if anywhere. My lower bound is just coming from supposing that the currency/GDP ratio stays constant.

    anon1: No, I think we should focus solely on the Fed's liabilities.

    RV,

    No, forget about the narrow, broad, and money altogether. As I said, think about the Fed as an intermediary, and the role that the Fed's liabilities play as media of exchange. If you write down the model, you would have to worry about private intermediation, and how the private intermediary liabilities compete with the Fed's liabilities. Old Monetarists did not think much about what financial intermediation was about. For example, Friedman's 100% reserve requirement would seem like a lame idea to anyone who thinks much about the role of financial intermediaries.

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  12. I think I'm having difficulties understanding how you get from A to B.

    For instance, you say that when reserves (currently in excess) become relatively less attractive, ultimately there must be less reserves and more currency (holding the IOR steady). I don't understand the underlying process that would produce this result.

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  13. Thanks for being specific.

    Here's the link to the comment:

    http://newmonetarism.blogspot.com/2011/04/qe2-is-irrelevant.html?showComment=1304054705412#c8250641682102449143

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  14. Hi Richard,

    This is like when a student with a wrong answer wants to know why what he/she wrote is wrong. It's a lot easier to give the right answer than to take apart the wrong answer and explain carefully why it is wrong. Suffice to say, in this case, I think most of what Andy had to say in the comment is wrong.

    JP,

    Suppose for the sake of argument that the demand for currency is inelastic in real terms with respect to everything. Nominal currency is C, price level is P, so real currency is C/P. The quantity of reserves is M, in nominal terms, or M/P in real terms. The Fed fixes M+C, and also fixes the IROR. Suppose that the demand for reserves falls in real terms, so if the Fed holds IROR constant, M/P must fall, but C/P is constant, so what has to happen is that P rises, M falls, and C rises. Somewhere in the adjustment process, as P rises consumers are going to withdraw cash from banks and the banks will withdraw the cash from their reserves accounts. To get serious about this you have to flesh out the model and do the dynamics, but that's the basic idea.

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  15. Ok, so to reword... when alternative assets beckon, banks spend their excess reserves on those assets, thereby pushing asset prices up. At the resulting higher price level, people want to hold more cash in their wallets than before. This higher demand for cash is ultimately satisfied by banks drawing down their reserves at the Fed.

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  16. Hearing why something is wrong is wrong, clearly, specifically, and intuitively is a great way to learn and teach -- and persuade.

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  17. Steve, re: your comment that "the Fed and the Treasury collectively are no better at helping us bear the maturity risk than is the private sector", I'd be interested in your views on Operation Twist. That seemed to be quite effective in 'pegging' yields, and I doubt that any private sector actor could have accomplished the same outcome.

    Thanks (anon mtm / anon reversal)

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  18. Steven:

    "holding constant the total quantity of Fed liabilities"

    But that's the whole trick. As soon as inflation threatens, the Fed uses its assets to buy back its liabilities (i.e., reserves). The Law of Reflux kicks in, and there is no inflation.

    I'd only start to worry if the Fed's assets were not enough to buy back its liabilities.

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  19. The currency in circulation is way too low relative to GDP. You said it yourself, the ratio is where it was in the 1960s. This exactly is the problem, the US economy has a deficiency of HPM, the vertical money, and an abundance of horizontal money. I believe the authorities know this and that is why currency in circulation has been growing at the 8 percent you mentioned recently. And you are right that theoretically a continuous increase of HPM will eventually cause inflation but given the massive deleveraging still going on, it is way too early for that. The excess reserves are irrelevant. And btw, the US is not backstopped by the US tax payer, but by its ability to print the reserve currency of the world. The tax payer is also irrelevant.

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  20. anon mtm,

    I may be wrong, but I thought the standard view of operation twist was that it was ineffective.

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  21. "Thus, the stock of currency seems important for the determination of the price level"

    Ok, assuming I understood you (May 17 @4:36)... It seems to me that the stock of currency isn't so much determining the price level, but acting passively to an already-increased price level, ie. prices are determining the stock of paper currency and not vice versa.

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  22. Stephen:

    I think you are right on the standard view of operation twist (OT), but there is some evidence that given its limited size it did have an impact. See for example this San Francisco Fed  note. In general, though, there is enough empirical evidence to take the portfolio channel seriously. The channel doesn't have to always work through the Fed, though, as it could work through Treasury buy back programs (e.g. 2000-2001) or foreigners purchasing our long term debt (Japan buying long-term treasuries in 2003 and 2004).

    Again, though, the Fed is not limited to the portfolio channel. It can signal the future path of interest rates (via a price level or nominal GDP level target) and that in turn could spur nominal spending. It worked well in 1933-1936. How do you wrestle with that experience?

    Finally, I get the sense that you are viewing the Fed at the zero bound as simply supplying another safe, liquid asset among many other big issuers of safe assets (e.g. Treasury, GSEs, big banks). While true, the Fed is also issuing the medium of exchange which these are player cannot do. Here it is unique and to the extent there is a medium of exchange problem (i.e. excess money demand problem) it can make a difference. Again, it would probably be most effective in doing so through signalling.

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  23. JP,

    Yes, I did not state that well. Currency and the price level are both endogenous.

    David,

    1. What's your interpretation of what is going on 1933-36?
    2. This isn't just a question of zero lower bound, I'm saying that this is how policy works whenever there is a positive supply of excess reserves overnight and the central bank is paying interest on reserves. Currently the value of an additional unit of reserves as a medium of exchange during the day is zero, and the Fed has no control over the quantity of currency used as a medium of exchange, except through changes in the IROR. Thus, you can't say that quantitative easing is going to work through some process that has to do with the Fed's unique ability to create particular media of exchange.

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  24. Stephen,

    I just did a quick post on 1933-1936 here: http://macromarketmusings.blogspot.com/2011/05/original-qe-program-smashing-success.html

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  25. Ok, so to make sure we are still on the same page, let me repeat in my own words... given that currency holdings increase passively with prices, and outstanding currency is increasing at 8% while real GDP growth is only growing at 2% or so, it would seem that people are adjusting to significantly higher prices. Which is odd since the Fed seems to think prices are not really increasing at all. Statistics showing growth in currency are probably a better indication of inflationary pressures than words emanating from the Fed. Is that what you mean?

    If so, I pretty much agree.

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  26. Yes, and I'm thinking that the prices are going to respond with a lag, so you see the inflation first in currency increases, then in prices. On what the Fed thinks it is seeing, or wants to see, that depends on what Fed official you listen to.

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  27. David,

    I see what you're getting at with 1933-36, but why do you judge that episode a success for monetary policy?

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  28. Stephen,

    Yes, it was FDR who made 1933-1936 happen not the Federal Reserve. What FDR did, though, is something that the Fed could do in principle. That is, the Fed could announce a level target (my favorite being an nominal gdp level target though a price level would suffice for now) and promise to purchase as many assets--not limited to treasuries--as needed to hit the target. In my view, that would have been much more effective than announcing an ad-hoc lump sum of $600 billion with vague goals (i.e. QE2).

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  29. Of course some people think that there were policies, particularly those relating to labor markets, that prolonged the Great Depression.

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  30. The WCURCIR measure of money that you use does not seem to tell us anything, especially if you look at the raw figures (not the percentage change figures) on the St Louis Fed site http://research.stlouisfed.org/fred2/series/WCURCIR. It rises through the recession, which is a strange thing for money to do in a period of contraction.

    Look instead at the graph on www.philipji.com/item/2011-05-11/how-much-longer-until-a-crash which tracks the whole period from 2001 to March 2011 accurately. It shows that we are certainly headed for a huge financial crash in the near future.

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  31. Yes, and there were some people who thought the world would end last Saturday.

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  32. "It shows that we are certainly headed for a huge financial crash in the near future."

    I have a bridge to sell you. Since you're a believer in fairy tales and unicorns, might as well get some real estate too.

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