Since the financial crises of 2008, the Federal Reserve has expanded its balance sheet from about $850 billion to about $4.5 trillion. In other words, the Fed has created $3.6 trillion of new money, representing more than 20% of U.S. GDP.
Back in 2008 and 2009 lots of smart people assumed that money printing of that magnitude would surely cause serious inflation, if not hyperinflation. And yet, with all that new money, inflation, at least as represented by the Consumer Price Index (CPI) has remained below the Fed’s target of 2%. Why? Why hasn’t the Fed’s extraordinarily loose monetary policy led to significant inflation?
In no particular order, here are seven possible explanations. Which ones are true? All of them.
1. Banks have not lent the money
Of all the reasons for why the Fed’s extraordinary monetary policy hasn’t led to inflation, this one is both the most obvious and the least controversial.
The mechanism of monetary policy is for the Federal Reserve to buy securities (e.g. government debt) from banks with newly created money. This newly created money is then available for banks to lend to businesses and consumers. Since banks historically earned no interest income on this idle money (“excess reserves”), banks should have incentive to lend the money in order to earn interest income.
The fable told in economics textbooks is that of the money multiplier and the reserve requirement. The story goes that once reserves are created on a bank’s balance sheet, the bank will then lend out all of it except the portion it is legally required to hold. For example, if $100 of new money is created by the Fed and deposited in a bank, and if the reserve requirement is 10%, then the bank will lend out $90. But that’s not the end of the story.
That $90 can then be used to buy machinery or hire workers or build a house, and that $90 will ultimately be deposited back at another bank (or the same bank, it doesn’t matter) by the receiver of the money (the machinery vendor, the worker or the homebuilder). Now the banking system can lend out another 90% of that $90, or $81. This process continues indefinitely ($100+$90+$81+$73+$66, etc.) and ultimately, $1000 of money is created, equal to the original amount divided by the reserve requirement (in our example, $100/.01). In other words, the money multiplier is 10, since 10x the Fed’s original deposit is created.
If this was the way the world really worked, then the $3.6 trillion created by the Fed would have really led to something like $36 trillion of new money (the reserve requirement in the U.S. is 10% on most balances). This would equate not to 20% of annual GDP but 200% of GDP. With that amount of newly created money, it is a near certainty that inflation would have followed.
Clearly, that hasn’t happened. Massive inflation hasn’t followed because the banks haven’t lent the money. The so-called multiplier effect simply hasn’t occurred. Instead, banks have kept most of the excess reserves on their own balance sheets, to the tune of $2.5 trillion. There are a number of reasons why.
First, the Fed, beginning during the financial crises began paying interest to banks on excess reserves. Hence, since banks do earn some income on unused reserves, they have less of an incentive to lend. Second, thanks to extraordinarily low interest rates set by the Fed (the Fed is targeting an interest rate when it buys securities with newly created money), banks earn relatively little interest income on the funds that they do lend. Why earn only a little income on risky lending when you can earn only a little bit less income without taking risk?
Third, banks are still repairing their balance sheets that never fully recovered after the financial crises of 2008. And given the severity of the last financial crises, banks now realize that they had better keep more reserves ahead of the next (inevitable) crises. Fourth, the Fed and other bank regulators, through various regulations and “stress tests” have significantly increased the amount of capital banks are required to have, and curtailed the amount of risk banks can take.
Lastly, and most importantly, banks haven’t lent because they can’t find very many creditworthy borrowers that want to borrow. Consumers, as a group, are still over-indebted. And businesses are facing the twin hurdles of global oversupply and “disruption” from easy-money fueled technology companies. With this onslaught, it is no wonder why most businesses have no appetite to borrow and to invest.
Before we move on, let’s revisit the stated purpose of easy monetary policy: to encourage banks to lend. As I said above, that banks aren’t lending all the money that the Federal Reserve created is common knowledge. And as I also mentioned, the Fed and other government regulators are actively forcing large banks to reduce risk. Seems a bit contradictory, doesn’t it?
This begs the following question: what is the true purpose of easy money, if not to directly stimulate the economy through increased lending? To recapitalize (bail out) banks? To raise asset prices? To simply appear to be doing something to help the economy, so that you’re not blamed for the next downturn?
2. The money has flowed overseas
Textbook economics dictates that the Fed can at least influence, if not control the level of inflation. By lowering interest rates and printing money, the Fed can stimulate lending, which stimulates businesses activity, which results in increased employment, which results in increased aggregate demand, which puts pressure on wages and ultimately prices.
However, as we’ve already discussed, banks aren’t lending as much as the Fed would like to U.S. consumers and U.S. businesses. But perhaps they are lending the money overseas? This is what is known as the “carry trade.” Made famous over the past two decades involving the Japanese Yen, it applies equally well to the United States. Simply put, borrow where interest rates are low (e.g. Japan and the U.S.) and then lend the money in emerging market countries where both interest rates and growth prospects are higher. In other words, freshly printed (digitally, that is) Federal Reserve money winds up not in the U.S. as intended, but instead financing Spanish real estate or Brazilian mines or Chinese factories.
So perhaps the textbooks are correct that low interest rates and new central bank money will lead to higher GDP and ultimately inflation. But in a world of free-flowing capital, that higher GDP and even inflation can just as easily occur in other countries rather than the country in which the money was created. In other words, in the small, closed economies of the ivory tower, perhaps an all knowing central authority can indeed control inflation. In the real world, perhaps not.
3. The CPI is understated
Like all government created economics statistics, the CPI is an enormously complicated statistical measure that very few people understand. To quote Wikipedia, the CPI is “a statistical estimate constructed using the prices of a sample of representative items whose prices are collected periodically.” But what are those representative items? What I buy and what you buy might not be the same. And what prices should be used? Prices in New York? In Detroit? In rural Alaska? And how should we collect these prices? And how often?
Yet those are probably the easy questions. There are much harder ones. What about quality changes? How should new cellphone features be factored into the price index? How about safer cars? Or less legroom when flying? And how about substitution effects? If the price of steak goes up, I might switch to chicken, which is cheaper. Since I no longer buy steak, should the price index only account for chicken? But if I really prefer steak, isn’t that really a reduction in my utility, and hence similar to a quality decline in my food consumption?
Perhaps the most controversial input in the CPI is how it accounts for housing, the single largest expense for the average consumer, and thus the largest component of the CPI. Rather than directly include the change in the price of houses, like it does for other consumer goods, the CPI takes into account something called “owner’s equivalent of rent” (OIR). This is a measure, based on surveys, for how much monthly rent homeowners believe that could get if they were to rent out their homes.
Leading up to the financial crises, housing prices where increasing at a rate double that of OIR. Many have suggested that the Federal Reserve ignored the obvious signs of the housing bubble because they were focused on inflation indices such as CPI, which vastly understated the inflationary impact of rising house prices.
The CPI is truly a black box, and I will be the first to admit that I have little understanding of what exactly is contained in that black box, or how that black box is constructed. And to be fair and truthful, you can find plenty of economists who will argue that the CPI overestimates true inflation (mostly due to quality increases) rather than underestimates inflation.
However, one thing is undeniable. As much as I hate to sound like a conspiracy theorist, I would be remiss to point out that the government has a huge incentive to understate the CPI, for at least two reasons. First, because many government entitlement programs, most notably social security are tied to cost of living increases. The lower the official inflation rate, the lower the entitlement payments the government is obligated to make. Second, inflation is a key component of reported economic output (i.e. GDP). The lower the inflation rate (in this case the GDP deflator), the higher the headline real GDP figure. All the better for incumbent politicians.
Long story short, given the government’s bias for lower inflation, I would guess that true inflation is perhaps 1-2% higher than the reported CPI number. But whether I am right or not, here’s the most important thing to remember. Measuring inflation is enormously complicated and messy. Even without a bias, this is art not science. So why should a central bank rely on such a figure, a figure who’s margin of error is probably at least a full multiple of itself, to justify printing trillions of dollars? To me, this is unwise, unscientific, undemocratic and bordering on criminal.
4. Asset prices are inflated
Take someone off the street (Main or Wall) and ask them what they think of the Federal Reserve. Assuming they know what the Federal Reserve is, they might say the Fed is doing a good job or a bad job. They might say that the Fed should do more to help the economy or less. They might say that the Fed should lower interest rates further or raise them. But if you ask them, regardless of their economic beliefs, to state one criticism of the Fed, I’d bet most would say the following: the Fed contributes to rising asset prices and to asset bubbles.
Remember the discussion of owner equivalent of rent from above? Just in case you don’t, we said that the housing component of the CPI reflects an estimate of changes in housing’s rental price rather than its sales price. Why is that? Because renting a home is considered consumption while buying a home is considered investment. The CPI is meant to measure consumption. Not investment. And therefore, not asset prices.
The Fed won’t admit they they create asset bubbles. But they do. Easy money in the 1990’s led to the first tech bubble. Easier money in the 2000’s led to the worldwide real estate bubble. Even easier money now has led to a bubble in all financial assets. Stocks, bonds, real estate, art, wine, you name it.
Let’s talk finance 101. Mathematically, the flip side of a low interest rate (technically, a low cost of capital) is a high valuation. In fact, the Fed has explicitly stated that they believe in what is known as the “wealth effect.” If your stock portfolio is higher and the value of your house is higher, then you are more likely to spend money, which should help the economy. Whether or not this wealth effect is real is irrelevant here. What is relevant is that higher asset prices are both a mechanical consequence AND a desired outcome of central banking’s loose monetary policy.
While the CPI might not reflect inflation, asset prices do. And the more risky the asset, the more the asset has been inflated. If this sounds scary, it should. Sooner or later, asset bubbles burst. When they do, financial crises tend to follow.
What asset inflation also means is that investors are paying more today for income tomorrow. We see this looking at metrics like Price/Earnings on stocks (very high) or Capitalization Rates on real estate assets (very low). These two metrics (essentially inverses of each other, hence the opposite direction) reflect, respectively, the high price paid today for a dollar of earnings from public companies or a dollar of cash flow from real estate investments.
Said another way, paying a high price now means that future rates of return on financial assets will likely be much lower than they have been in the past. This is great for today’s sellers of assets, who are receiving very high (inflated) prices. Sellers can use that money to consume, theoretically helping the economy (another impact of the wealth effect). However, buyers of financial assets pay more now, and will receive lower cash flows later on, reducing future consumption. So, not only does asset inflation result in those dangerous asset bubbles, it also pulls consumption forward, meaning lower economic growth in the future. Not to mention, you’re killing the business models of insurance companies and pensions, which rely on investment income to meet future obligations. Truly a disaster waiting to happen.
Long story short, while the $3.6 trillion the Fed has printed (and the corresponding reduction in interest rates) may not have led to very high CPI figures, it has helped lead to asset inflation. And the riskier the assets, the more inflated they are. This has gotten the world into trouble before. It will do so again.
5. Inflation is much higher for the wealthy
When we were talking about the CPI, I mentioned that there are many assumptions that have to be made in order to construct such an index. For instance, what products to include. Also, who to survey. In reality, the government folks (the Bureau of Labor Statistics or “BLS”) who are responsible for publishing the CPI do construct several different indices based on who they survey. For example, they have separate price indices for urban consumers and rural consumers. They also have a price index for consumption by the elderly.
To my knowledge, none of those price indices show inflation levels that would worry the Fed. However, I believe there is a subset of American (and global, for that matter) consumer that is experiencing inflation on a level that should concern the central banks of the world. That consumer is the wealthy.
Whereas the CPI has been running under 2% for many years running, I believe that a properly measured index for wealthy consumers would show inflation running at somewhere between 6-10% annually. In other words, perhaps 3-5 times the CPI. And the richer the consumer, the higher the inflation.
What has happened to this segment of consumer is a classic wage/price spiral. In a textbook wage/price spiral, money printing heats up the economy causing prices to rise. Workers seeing prices rise, demand higher wages. Higher wages result in businesses raising prices to offset higher wage costs. Higher prices cause workers to demand even higher wages, etc, etc, etc.
In today’s world, that is what is happening but the money first flows through Wall Street, and then flows to the owners and operators of high risk assets, such as hedge funds, tech entrepreneurs and public company CEOs. Those “workers” see their cost of living go up (e.g. housing prices in Manhattan or Greenwich, CT) and demand higher compensation and the cycle continues.
I freely admit that I don’t have hard data to back up my contention. However, observation and intuition says that the annual increase in the cost of living in a “1%” city like New York or San Francisco has clearly increased well beyond 2%. So have the costs of eating in a 4-star restaurant, imbibing a grand cru burgundy, staying in a Four Seasons hotel, paying full-fare for an Ivy League education (or buying your kid’s way into Harvard) and many more such worldly pursuits.
To be clear, I’m not advocating that you feel sorry for the rich. Not at all. For incomes of the wealthy have increased correspondingly. Remember, the point of this article is to explain why the Fed’s loose monetary policy hasn’t led to inflation, at least as measured by the CPI. However, in my view, it has led to very high inflation for this subset of consumers. Moreover, the asset inflation that I talked about above, plays a large role here too. For who owns most of the financial assets in the world? The wealthy. So just as there is price inflation for the 1%, there is massive wealth inflation.
If this sounds to you like I’m blaming the Federal Reserve for the enormous increase in income inequality over the past few decades than you are exactly correct. Regardless of intention, good or bad, the money that the Fed, and other central banks have printed has, for the most part, not flowed to Main Street. And it has not flowed to the middle class. Instead, it has gone to the wealthy, the super-wealthy, and the uber-wealthy. It has gone to Wall Street and to New York. It has gone to Silicon Valley and to San Francisco. It has gone to hedge funders and investment bankers, to tech entrepreneurs and venture capitalists, to CEOs and star athletes and perhaps worst of all, to politicians or at least ex-politicians.
6. The Fed is chasing its own tail
The next explanation for why the Fed’s easy monetary policy hasn’t led to inflation is what I will call the Fed chasing its own tail. What I mean is that contrary to intention, cheap money actually leads to lower prices rather than higher prices.
Let’s once again review the textbook rationale for easy monetary policy. Printing money and lowering interest rates leads to more lending and borrowing, and therefore to more investment and more spending than would otherwise happen without easy money. The implicit assumption is that the economy is operating under capacity (i.e. there is unemployment) and therefore, that the additional spending and investment expands the economy until it reaches full capacity, at which time inflation should occur.
Other things equal, I agree that low interest rates and easy money leads to more investment and, especially to more riskier investment. However, like everything in the real world, other things are not equal. As I wrote about extensively here, I believe that a substantial portion of the investment fueled by easy money actually retards economic growth, lowers employment and reduces overall prices (though not to the wealthy, as discussed above).
The prime (get it?) example I used in my previous article was of Amazon (see, “Amazon Prime”???). Amazon is a company that absent cheap money would likely not exist since it has no ability to actually make money. Yet, it has “disrupted” traditional retailers, resulting in hundreds of thousands of lost jobs, a multitude of retail bankruptcies and yes, lower prices.
This trend is prevalent throughout the economy with few companies or industries spared from Fed subsidized tech disruption. In other words, easy money does indeed spur some (i.e. tech) investment. But when taking into account the disruptive secondary effects, we find that overall investment, employment and economic activity are actually lower. Prices are lower too, contrary to what the textbook models state. Consumers benefit from lower prices for the time being. But mostly, the benefits accrue to a handful of venture capitalists, tech entrepreneurs and highly skilled developers, all part of the 1%.
7. Deflation is winning
I now present to you one final explanation for why central bank money printing has not led to inflation: it is being offset by deflation.
Let us remember why the Federal Reserve and the other central banks of the world are pursuing extraordinary monetary policy, to the tune of trillions of dollars created and zero or even negative interest rates. They are doing these things in response to the financial crises of 2008 and the global “Great Recession” that followed. Governments and central banks were, and are, desperate to prevent falling prices. This fear has led to a money experiment never before seen in 5000 years of recorded history.
We need to ask ourselves why did the financial crises happen in the first place. Obviously many, many books have been written about the causes of 2008. Unfortunately, nearly all of them have been wrong. As briefly as possible I’ll try to summarize the true causes.
The financial crises, like all financial crises, was a natural, market reaction to an economic bubble fueled by cheap money, subsidized risk and the perverse, short-term incentives that stem from cheap money and subsidized risk. What made this crises worse than most in recent history was that the market was trying to correct not years of financial mismanagement, but decades.
Erroneously believing that monetary policy could (and should) smooth out the business cycle and prevent recessions, the Federal Reserve has repeatedly printed money, set interest rates below their market rate and bailed out banks and other financial services firms. Each time it has done this, it has led to an even larger asset bubble and further reinforced the message that risk takers will be bailed out. Naturally, each bailout has been larger than the one before. 2008 was very large. Yet, the Fed, continued and wildly expanded its playbook, still believing that the cure for too much money is more money.
Unfortunately, the cure for too much money is not more money. Money needs to be extinguished. Oversupply needs to be reduced. Companies without profitable business models need to disappear. Over-leveraged banks, regardless of size, need to fail. Investors who took stupid risks need to learn painful lessons. This is the only way a free market can work. And this is the only way an economy can grow over the long-term.
Even though the central banks of the world have created trillions of dollars of new money, that new money is still fighting against gravity. That gravity is a massive deflationary current worldwide stemming from decades of easy money. So in one sense, what the Fed is doing is working. Prices are not declining, and are, in fact not far from the Fed’s target of 2% inflation. Moreover, we are not, at least officially, experiencing “depressionary” conditions.
Why hasn’t trillions of new dollars caused inflation? It has, but we don’t notice in measures such as the CPI because it is fighting the gravity of deflation. Sooner or later, however, gravity wins. It always does.
Conclusion – what comes next?
The past eight or so years have seen the central banks of the world print trillions of dollars. We see negative interest rates in parts of Europe and in Japan, something that has never happened before in human history. Now we hear calls from many mainstream economists for central banks to raise their inflation targets even higher, and louder and louder shouts for “helicopter money.”
Yet, inflation remains “stubbornly” below the target set by the Federal Reserve and most of the world’s central banks. Meanwhile, the world’s economies are growing slowly, if at all. And while the stock market and other financial asset prices continue to rise, income inequality continues to worsen, as does the political unrest that income inequality fosters. We see unemployed young people with student loans they will never repay. We see unprecedented amounts of homeless on our city streets. We see anti-capitalist, socialist and fascist politicians worldwide gaining votes and gaining power.
From this mess there are two conclusions one can draw: either central banks aren’t doing enough or what they are doing isn’t working. Mainstream economists have concluded the former. Print and spend, is what they say. How much to print and spend? Until it works. What if it still doesn’t work? Then print and spend some more.
However, one need only look at Japan to see this folly. More than two decades of extraordinary money printing and extraordinarily low interest rates have done nothing to awaken Japan from a generation-long depression. Meanwhile, Japan’s population ages and shrinks, an effect, not a cause of a stagnant economy.
I said it earlier and I will say it again. Easy money and subsidized risk cannot solve the problem of an economy ailing from decades of easy money and subsidized risk. But central banks and politicians will continue to try it. Because they have no understanding of what truly ails the economy and know no other way.
So what happens next? With no end in sight to more money printing and continued low interest rates, is inflation ultimately inevitable? Not necessarily. The U.S. and the rest of the developed world can continue limping along with slow growth, low inflation, continued income inequality, worsening demographics. We are all Japan.
Sooner or later, another financial crises will hit. Perhaps months from now, perhaps years, perhaps even decades. Will the central banks be able to save us again? For sure, they will try. But eventually they will fail. Whether the endgame is massive deflation or hyperinflation is unknowable and probably immaterial.The result will be the same. Crises. Depression. Ultimately, a financial reset.
It will be very painful. But it is, unfortunately, very necessary. And just maybe, 100 years from now, historians will look back and ask themselves how could we have been so primitive, so unwise, so naive to think that printing money is a good idea.