How can the Fed control inflation?

What Is Inflation?

Inflation is when more money is chasing less supply. Effectively, inflation and deflation are a question of supply and demand. The supply of money depends both on the amount of actual money in circulation (the M2 supply) as well as the velocity of money (how many times each dollar circulates within the economy) and the demand for money is the goods and services that people want to buy with currency. While in moderation, inflation (generally aimed to be around 2%) is healthy because it indicates economic growth (since people are incentivized to invest rather than hold their money), hyperinflation and deflation can both signal economic disaster.

Effectively, we can define the effective supply of money as the combined actual monetary supply and its velocity to figure out the effective dollars in circulation. This is coincidently known as the nation’s Gross Domestic Product (GDP). Logically, if GDP grows without any increase in production, individuals must be paying more for the same amount, meaning inflation.

Why Are Deflation and Hyperinflation Bad?

In short, deflation disincentivizes investments because investors would rather sit on their cash rather than lend it to banks (who then lend it to companies) or pour it into risk assets (furthering economic growth). Thus, it is clear that deflation prevents the free flow of capital and disincentivizes economic growth.

However, readers might then wonder why hyperinflation is bad. The short answer is that hyperinflation provides too much of a good thing. First, hyperinflation will cause the country to be less able to buy imports due to having a weaker currency. Moreover, hyperinflation can alarm investors and cause a capital outflow, preventing investment in investors’ home countries. In effect, the major downside of hyperinflation is capital redistribution since real assets will tend to increase with hyperinflation while less economically advantaged people might not experience real wage growth, increasing economic disparities and reducing social cohesion. Furthermore, hyperinflation is often self-perpetuating because once investors begin to fear losing their money to inflation, they are incentivized to spend their money as fast as possible, increasing the velocity of the monetary supply even further. Once people lose trust in a currency and try to get rid of it as fast as possible (or stop accepting it), a nation’s economic prosperity is on the brink of collapse. Nevertheless, despite rampant fears in the US, hyperinflation is rather difficult to achieve when the US has most of its debt denominated in dollars since it can print its obligations away.

Sidenote: Most cases of hyperinflation: Turkey, Germany, Venezuela, Zimbabwe depended on a supply shock (ie. production rapidly decreased while demand stayed the same) or a need to meet external debts in other currencies (either due to a sustained foreign trade deficit or borrowing). Here, devaluing their native currency would not solve the problem by itself because each unit of currency had to compete for very limited resources or because as their currency grew weaker, it would also take more of it to pay their external debts. See more cases of monetary supply expansion and hyperinflation at this study.

In a further case study, I will examine Japan’s deflationary crisis and how it has sustained such low interest rates on government debt.

How Can the Fed/Treasury Control Inflation?

The Fed can set the Fractional Reserve Banking rate, which is effectively what percentage of a deposit a bank is forced to keep on hand. Banks are economically incentivized to loan out as much money as possible to good borrowers in order to collect interest. Thus, by lowering the fractional reserve banking rate, the Fed can incentivize banks to increase the money in circulation by “creating” money through loans. A brief example is below.

  1. Sally gives the bank $10k and will collect a 2% interest rate. The Fractional Reserve rate is 10%.
  2. The bank keeps $1k in its vault and loans out $9k to Bill who will use it to open a bakery. Bill will pay 10% interest on this loan.
  3. Bill then uses this loan to buy a bakery. The previous landowner deposits his $9k payment at the bank.
  4. The bank can then loan out $8.1k, keeping $900 for the landowner’s deposit.

Here, from Sally’s original $10k, we created $17.1k worth of transactions (and investments if we count Bill’s new bakery as one). Thus, despite the Fed not increasing the supply of money, we’ve increased the velocity of money by having it circulate through the system multiple times.

However, the situation turns much bleaker during a credit contraction. What if Sally begins to fear that the bank will collapse and wants to pull out her money from the bank? Since much of the bank’s assets will be tied up in loans, and the bank only has 1k in deposits for her, the bank might face a liquidity crisis and be forced to sell off Bill’s loan at a price lower than the market rate. Furthermore, if Bill fails to pay off his loan, the bank is left with a liability for the unpaid amount. Thus, during a credit contraction (see Ray Dalio’s article for more info), banks might find once profitable loans now become liabilities, forcing the bank into insolvency.

Here lies the problem: banks are so afraid of a liquidity crisis that instead of loaning out their reserves, despite the Fed lowering fractional reserve rates, banks would prefer to not use that money. Thus, the velocity of circulating currency remains low no matter how much the Fed prints.

We can measure how much banks are lending out through fractional reserves by calculating the money multiplier or the M2 supply/Monetary Base.

Federal Funds Rate

The Fed has another tool for controlling inflation: interest rates, specifically the federal fund rate, which is the interest rates banks charge to lend or borrow reserves from one another (to meet reserve requirements see 1). By setting the federal fund rates, which banks largely use to define their own interest rates for borrowers (and depositors), the Fed can make credit easier to obtain (if interest rates are lower, the cost of interest is lower, so it is more affordable for borrowers to borrow). Furthermore, if real interest rates go negative (as compared to inflation), it makes more sense for borrowers to borrow because the dollars they borrow today are worth more than they would be tomorrow. Meanwhile, lenders are disincentivized from lending since they would seek better avenues of return. Thus, supply of credit contracts while demand for it increases, so the price (interest rates) of credit increases.

Altering interest rates via Quantitative Easing and Open Market Operations

Open Market Operations (OMO) is where the Fed buys and sell short-term government securities to influence interest rates by adding to demand or supply. In OMO, the Fed will either print reserves to buy securities with or sell securities to investors to expand or contract the monetary supply (as well as manipulate the yield curve). However, with short-term yields nearing 0, the Fed turned to a dramatic new tool: Quantitative Easing.

Here, the Fed bought longer-term government securities or loans as well as loaned money out to American institutions, especially in the QE round of 2020 (see Term Auction Facility or Term Securities Lending Facility). This exposed the Fed to long-term interest rates (and implicitly made them short on shorter term interest rates, which will be discussed in a future article), but by creating demand for bad debts (toxic assets), the Fed lowered interest rates, which as explained with the Fed Funds rate, ought to have increased the supply of credit due to its more ready availability. In addition, by printing reserves for these assets (toxic loans), the Fed also directly increased the monetary supply and injected dollar liquidity into the market. There are several problems with the Fed acting as a buyer of last resort, but these will be discussed at a later time.

Fiscal Policy (mainly taxes) and Forward Guidance

While this is not directly under the Fed’s control, fiscal policy plays a vital role in controlling the supply. First, the government can cleverly utilize the tax code to incentivize certain economic actions or disincentivize others. Furthermore, by decreasing taxes for lower income people, the government can drive up demand since households will have more disposable income to use to buy products, increasing both the monetary supply and velocity. It is questionable whether this works for the wealthy or corporations, since much of that extra money will go towards financial assets, not productive assets or goods that will increase money velocity.

Moreover, as the buyer of last resort, according to Modern Monetary Theory, the government can also function as the buyer of services (ie. the employer) of last resort. Effectively when demand for goods has dried up (such as during a depression) and the dollar is deflationary, the government can a) maintain a structural labor force and b) induce demand by employing the unemployed.

Finally, as will be discussed in the case of Japan later, forward guidance plays a powerful role in the Fed’s control over interest rates. As long as the Fed is perceived as having control over inflation, since markets are forward looking, the Fed can hint at certain policy changes and see the market react as if they had occurred without actually implementing them. Of course, such a strategy will eventually fail if investors lose confidence in the Fed, but through proper utilization, the Fed can enact change with a delay, allowing economic issues to resolve themselves prior to intervening.

Then Does Quantitative Easing (Increases in Monetary Base) Increase Inflation?

The short answer is sort of. Again, the government generally relies on QE to induce inflation when the economy looks like it is approaching deflation or a recession. Although QE increases the monetary supply for a decent period of time (by buying long-term loans for currency that will not be removed from supply for a long time), we have not experienced the expected hyperinflation post 2008’s QE. As the chart of M2 Velocity below shows, one of the reasons QE did not cause a rush of inflation is likely that velocity never recovered, so the money supply effectively remained the same pre-2008 crash and post-QE.

Although the M2 supply chart is usually used to calculate inflation, we’ll use the broadest monetary chart, the M3. The two are largely the same. One of the factors that prevented rapid inflation following the expansion to MB post-QE is that the M2/M3 remained largely stable. This is because following 2008, banks were less willing/able to use fractional reserve banking, negating an increase in the M2 supply despite the massive increase in MB. Since banks kept much of the injected QE on their balance sheets (to offset toxic assets), this money did not circulate into the economy and increase inflation. This no longer holds true and suggests that today’s scenario might end differently.

As we will see, investor confidence in the Fed as a buyer of last resort has led to some excessive risk-taking on Wall Street. Nevertheless, the market continued its bull run following the end of QE in 2014. Thus, halting QE is historically unlikely to directly crash the stock market (unlike rising interest rates as a result of QE-derived monetary base expansion, which combined with global trade tensions in 2018 is blamed for the 2018 crash).

A large portion of the funds from government spending appear to have been pumped into financial markets, preventing a trickle down supply of money into the economy that would lead to noticeably rising prices. Once the economy opens up, and investors begin to sell their gains and spend their money (such as on rent once the Center for Disease Control’s rent forbearance moratorium ends on March 31), monetary supply velocity will likely increase, which the Fed might be currently discounting.

Then, Do Rising Interest Rates Curb Inflation?

While widely believed to halt inflation, rising interest rates inherently increase the monetary supply (over the longer term). In actuality, while the actual monetary base will increase, it is more expensive for investors to borrow, so the supply of credit contracts, which means less money flows through the system (and there is less demand for goods and financial markets). Furthermore, high interest rates diverts capital flow from risk assets towards a guaranteed return from bonds as long as investors don’t believe that inflation will outweigh the return. Nevertheless, besides selling assets, the Fed has almost no way to decrease monetary supply beyond decreasing credit without raising expanding supply of its assets by selling them. Effectively, the Fed could sell assets (decreasing monetary base), stop printing (keeping Monetary Base the same), or wait for a recession to dramatically crash credit supply (crashing the M1/M2 as well but not affecting monetary base) as bad assets become liabilities and worthless.

Interesting Fact: During a recession, while M1/M2 can crash, the monetary base will not, since seeing our Sally example, when the bank loaned out 90% of Sally’s deposit, Bill paid a seller $9000 in “real” money, so even if Billy’s bakery turns out worthless, Sally will have $1k in the bank, and the seller will have $9k of her original deposit, so the $10k cannot disappear from circulation as long as buyers and sellers are matched (and money doesn’t flow out). A caveat is that in some odd scenarios, the value of that $10k can be inflated away if faith in the dollar collapses…

Herein lies the Fed’s greatest weakness: market perception. Once investors believe the Fed has lost control of inflation and interest rates, the Fed will have to fight the market to enact any changes. Perhaps, because markets believe that rising interest rates will stop inflation, participants will react accordingly and stop trying to spend money as fast as possible, decreasing the velocity of money in a self-fulfilling prophecy. If the narrative dramatically changed (see counterargument), we might obtain a different result. By controlling investor perception, the Fed can make raising interest rates (or even suggestions to do so) have meaning.

Sidenote: Rising interest rates often attract foreign investment in government debt, driving demand for the currency and decreasing inflation. (This rising value of the currency also decreases demand for the country’s exports which could potentially reduce supply according to demand-side economics and eventually lead to inflation until you hit an equilibrium). Of course, with rising interest rates, you lose the incentivization for investors to invest and further economic growth since they are more incentivized to save.

Counterargument: Until economies hit saturated production, lower interest rates can actually lead to deflation in a modern economy. This is because with technological innovation, cheaper money leads to more advances and economies of scale, dramatically increasing supply. In this supply-side argument, if interest rates increase, companies will be unable to finance innovation and decrease production, leading to inflation if supply decreases faster than demand.

How Might the Fed Curb Inflation?

To reduce monetary velocity, the Fed will likely raise interest rates, and to reduce monetary supply, the Fed might be forced to sell its long-term loan assets at a steep discount (due to its flooding of supply), which would further raise long-term interest rates. Effectively, except in the most dire of scenarios, the Fed will be able to contract monetary supply to sufficiently curb inflation, at the expense of increasing interest rates, which would likely contract free-flowing credit and crash the stock market, which is still flush on stimulus dreams.

Thus, the safest assets are one’s that are short bonds (and long rising interest rates), but there is the real risk that the Fed will overcorrect the interest rate. (Unlikely because of Powell’s fears of pulling a Japan). Thus, investors should hedge market risk in case stocks crash and send a wave of investors toward safe-haven assets like treasuries. That Wednesday’s treasury auction (March 10) saw a decrease in yield rates implies that there is significant demand at current treasury rates, signs of which were talked about in my first article. However, I believe this is merely interest in safe-haven assets following excessive rises in stocks.

A similar way of expressing this trade would be to short over-hyped tech companies that have bubbled on stimulus and long cheaper, still innovative companies. In a rising interest rate environment, overleveraged investors will likely be forced out of expensive tech stocks, while innovative companies will still thrive with some inflation. Although both may fall, investors can leverage the spread in a long-short portfolio. While less safe as a hedge against over-hyped tech, many non-tech stocks in the S&P500 remain historically undervalued.

Finally, while crypto investors are unlikely to experience hyperinflation given the Fed’s current iron control over bond yields (and Japan’s ability to hold near negative interest rates for decades without rampant inflation, which while vastly different from the US’s case, proves it is possible), the Fed will likely under-account for inflation, so Bitcoin as a digital gold will likely experience some gains under this current narrative. Nevertheless, if the S&P500 crashed, much like the scenario described above, crypto would likely fall with it as investors panic sold crypto.

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