The Boy who Cried Deflation!

Understanding the monetary system and why we shouldn't fear the 'printing press'

I've covered this topic before in recent weeks but the inflation story has since gained more momentum. As the end of Covid-19 draws closer the markets are beginning a process of repricing. 

​The sell-offs in government bonds in February and March has been fascinating to watch. It's classic game theory between the Fed (US central Bank) and the bond market. The concern among bond investors is that as economies re-open, consumer spending, in addition to continued government stimulus, will ignite inflation and erode future returns.

Bonds provide investors with regular fixed income over 3 months to 30 year durations. Higher Inflation, however, affects the price of bonds as the future value of that income depreciates. The Fed, however, remains steadfast in its conviction that inflation is transitory and rate hikes are unnecessary. Markets are not buying it though, explaining the volatility in bond markets. Inflation has the markets rattled.

An inevitable collapse in the US dollar and runaway inflation has been the narrative in financial media for almost a year since the outbreak of the pandemic. Given these sensationalist views, and a general misunderstanding of what it really means to 'print' money, many analysts have overplayed the threat of inflation even comparing the US economy to  "The Weimar Republic". 

As the US is the world's largest economy the demand for dollars ensures its status as the global reserve currency. The US exchange rate relative to the other world currencies tends to remain strong as result which allows its central bank, The Fed, to print money without badly effecting the dollar's value. 

When financial conditions become tight during a recession, the central bank's aim is to reduce the costs of borrowing and provide emergency lending to commercial banks, investment banks, and the federal government. This ensures the continued flow of liquidity and credit throughout the financial system. The central bank does this by crediting the reserve accounts of these institutions at the central bank. In short, it 'prints' digital money and transfers it to the accounts of large commercial banks.

In return for this money the banks must swap existing assets with the central bank as collateral. These assets include 10, 20, 30 year government bonds and long-dated mortgage-backed securities. In effect, the banks are giving up less-liquid assets for cash in order to meet their day to day operations. By giving up these assets they are also giving up interest rate earnings that they would ordinarily receive on those assets. As the old saying goes 'there's no such thing as a free lunch.' 

Similarly, when governments need money, the central bank buys government bonds that the Treasury department issues on the bond market. These bonds are loans that pay an investor an interest rate for buying the bond from the treasury. Usually central banks enter the secondary market and buy the bonds at a later date from other banks and financial institutions. The purchasing of these bonds drives up their values and lowers the interest rate issuers need to offer given the higher demand. These actions form the basics of Quantitative Easing and studies have shown that QE has little to no effect on consumer prices. 

​The chart below elaborates further. Notice over the last 50 years when, despite the money supply (M2) increasing, the velocity of money has been declining over time. The velocity of money refers to the speed at which money exchanges hands in the real economy i.e the rate of spending among consumers. 

Fig 1 showing the inverse relationship between money growth and velocity

QE has been found to have no effect on inflation because commercial banks (who are the real "printers" of money) don't increase lending to the real economy. Low interest rates make it less profitable to do so. Instead, banks prefer to invest their profits in stock markets where they earn a higher return.

Velocity declined during the Great Financial Crisis despite huge amounts of 'money printing'. In fact, that crisis over ten years ago was the beginning of large scale money printing programmes in the US and Europe. Both economies, however, experienced long periods of deflation. Real wages stagnated, and tax hikes reduced consumer spending. Crucially, central bank money creation did not trickle down to the real economy. 

Moreover, newly created money stays largely within the financial system as collateral. The financial system is highly hypothecated where debt often just replaces other forms of debt or collateral. This is why developed economies have not experienced a collapse in their currencies or had hyperinflation.

While governments in most rich countries during the pandemic provided direct lending to businesses and consumers in the form of 'helicopter money' these programmes are likely just a once off. If inflation worsens it will probably arise from continued supply chain bottlenecks. Poorer countries in the developing world are experiencing the same inflation pressures too despite receiving little or no government supports. 

The recent sell-offs in US bond markets earlier this month and late February show, nonetheless the anxiety that prevails among investors about inflation either way. Sensationalism in financial media about hyperinflation will do little to help.

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