“Inflation is always and everywhere a monetary phenomenon” – Milton Friedman
Except when it isn’t.
Since Lehman Brothers collapsed in September 2008 the Federal Reserve has expanded the US monetary base by around 300 per cent. The Fed continues to purchase $US85 billion ($93.43 billion) per month in assets to ensure the liquidity and stability of the financial system, effectively flooding the banking sector with fresh money.
Conventional wisdom suggests that inflation should have picked up. Indeed, the Fed needs it to do so. In the US there were even long, drawn-out political debates about how the central bank was actively debasing the currency and making its savings worthless.
The result? Consumer prices have increased by 6.9 per cent since Lehman Brothers collapsed, or a paltry 1.3 per cent per year.
Why has there not been more inflation? The Fed wants it, the economy needs it, and yet the evidence is that the rate of inflation is actually slowing.
It is an important question, particularly given the expectation that the Fed will begin to taper its asset purchasing program. The problem is that the Fed has a dual mandate, a commitment to maximum employment and stable prices (which for the Fed is regarded as annual inflation between 1 and 2 per cent).
The employment side of things has improved significantly. The unemployment rate is down to 7 per cent, which is far from ideal but certainly a vast improvement from its peak. Non-farm payrolls have expanded by 2.3 million over the past 12 months and are beginning to show the sort of resilience expected in an economy that is recovering.
Employment is strong enough to justify a taper if the Fed’s sole mandate were to promote employment. Monetary policy is rarely this loose when the unemployment rate is at 7 per cent.
But slowing inflation has complicated matters. The personal consumption expenditure deflator – the Fed’s preferred measure of inflation – slowed to 0.7 per cent over the year to October. The core PCE deflator, which removes volatile items, rose by just 1.1 per cent.
The Fed is unlikely to pull the trigger if it believes that a taper will cause more disinflation. That’s fair enough, but how concerned should it be? And why is inflation not higher?
There are two central factors that have kept inflation contained despite the surge in the monetary base: money in circulation, and expectations.
First, it is not so much the monetary base that is important but the money in circulation. What matters is how willing households and businesses are to spend and banks to lend.
The global financial crisis resulted in a sharp fall in aggregate demand, with the economy able to produce much more than it was willing to consume. Despite significant stimulus from both the federal government and the Fed, this shortfall in aggregate demand persisted with households and businesses preferring to save or deleverage rather than spend.
The velocity of money – a measure of how frequently money changes hands – has declined to its lowest level since around 1950. With a significant share of the Fed’s stimulus either sitting unused in bank accounts, seeking risk overseas or creating domestic asset bubbles, the decline in the velocity of money has allowed the monetary base to increase without putting pressure on inflation.
Second, expectations matter. The year-to-year movements in inflation are largely due to two factors: expectations and short-term fluctuations. Evidence suggests that most prices are ‘sticky’, meaning that price-setting is staggered over time. Changes in ‘sticky’ prices are based on expectations for inflation, which for many businesses will reflect past inflation. Expectations can become a bit of a self-fulfilling prophecy and as long as they stay anchored at normal levels, then realised inflation tends to do so as well.
Obviously there are many prices that adjust frequently – petrol and food are just two important examples – but generally concerns about inflation come from the ‘sticky’ component.
So a decline in money circulation and anchored inflation expectations have ensured that the Fed’s bond-buying activities are not contributing significantly to inflation. Expectations, and the general difficulty in lowering nominal wages, have also ensured that deflationary pressures never took hold either.
But what will happen if the Fed tapers?
When the taper commences it will be because the Fed believes the improvement in the labour market is sustainable, and if that is the case then disinflationary pressures will eventually disperse as job competition creates wage inflation.
An improving labour market will encourage more business investment and household spending, and we should see the velocity of money pick up a bit as a result, further contributing to inflation.
Offsetting this to some extent is that the US dollar will rise once the taper begins, creating additional disinflationary pressure. But trade is relatively small in the US, so importing lower inflation is less of a concern there.
For the Fed, the focus should not be on inflation right now but on expected inflation. Expectations remain around that sweet spot between the Fed’s 1 to 2 per cent target band, and that includes the assumption that the Fed will begin to taper.
Consequently, inflation should not be of great concern for the Fed right now. Obviously it would prefer higher inflation – that is a given – but let the labour market deal with that. If the Fed believes that the improvement in the labour market is sustainable then it will have all the justification it needs to begin to taper sooner rather than later.