The “Inflation By Next Year” Meme
I’m really interested in the “deflation now, but inflation in a year” meme that’s a lot of pundits and bloggers have picked up on. This alphaville post is the closest thing I’ve seen trying to explain it–
Merrill Lynch’s US economist Drew Matus made an interesting point on this issue during the bank’s 2009 economic outlook presentation today — namely that if the Fed’s liquidity programmes prove successful and banks actually do start lending to each other once again, the money multiplier — the broken thing that’s been preventing inflation so far — will suddenly start coming into effect
Paul Kedrosky saying something similar on his latest Daily Beast article:
Avoiding inflation after so much stimulus will be like avoiding acceleration after having pressed the gas pedal flat to the floor in a truck that has now swapped going uphill for going downhill.
As hard as it might be to imagine now, it seems entirely likely that a year or more from now we will be faced with soaring gas and food and commodity prices, and worrying how to get the inflationary genie back in the bottle. I know, I know, it sounds nuts, but trust me on this: We’ve already loaded the system with the necessary dollars to do the deed—the trick will become avoiding hyperinflation of the kind that kills currencies, as happened in the Weimar Republic.
BUT remember Robert Hall’s position on inflation:
Many economists have become concerned that the Fed’s huge expansion of liquidity amounts to a monetary expansion that will lead to an explosion of inflation. We believe that this concern is totally misplaced
This is one of the most interesting things I’ve read and that not many people have picked up on so here’s the copy:
If the Fed wants to stimulate inflation—as it did when deflation threatened in 2002—it buys Treasury securities from financial institutions and pays for the securities by increasing balances in banks‘ reserve accounts at the Fed. Banks generally prefer not to hold reserves above a fairly low level. Until recently, the reason was that reserves paid no interest. Now the Fed pays interest on reserves, but at rates below what banks can earn on their money by, for example, lending to other banks. As banks trade away from their excess reserves, they bid down interest rates, simulate economic activity, tighten markets for goods and services, and drive up inflation. The Fed keeps inflation on track by adjusting reserves. Because reserves fluctuate for many reasons, the Fed—and almost all other central banks—keeps its eye on the interbank lending rate rather than the quantity of reserves. The Fed lowers the rate if it thinks inflation is below target and raises the rate when it is above target. This feedback approach has delivered reasonably stable inflation for the past 25 years.
A liquidity expansion is different from a monetary expansion. In a liquidity expansion, the Fed sells Treasury securities and uses the proceeds to buy assets from financial institutions. No change in reserves occurs directly from this step. In a monetary expansion, the Fed buys Treasury securities and issues new reserves, thus expanding the volume of reserves outstanding. In normal times, when most financial assets are safe and trusted, a liquidity expansion would have almost no visible effect. During a financial crisis, a liquidity expansion drives down the elevated spread between non-government financial assets and Treasury securities.
The purpose of a liquidity expansion is to save the economy from the consequences of a financial meltdown, which otherwise would lead to diminished economic activity with the side effect of lower inflation or even serious deflation, as occurred in the Great Depression. But a liquidity expansion will not lead to inflation if no monetary expansion occurs. Rather, as it gains its desired effect of restoring normal conditions, its effect on the economy disappears—a liquidity expansion can save the economy from deflation but cannot ignite inflation. Only bad monetary policy can cause inflation. There are no indications today that the Fed will depart from its 25-year policy of using monetary policy to keep inflation at low levels.