Monthly Archives: May 2020

Inflation and Coronavirus Monetary Policies

Is there any reason to think that inflation might increase in the near future after the current coronavirus lockdowns and stay-at-home orders end? The Federal Reserve is engaging in extraordinary policies that will substantially increase excess reserves in the banking system. That said, the Fed did similar things during and after the Financial Crisis of 2007-2008 and inflation has been benign since. Are the current policies as likely to have little or no effect on inflation?

There are contrasting views by experts, among them Tim Congdon in an op-ed in the Wall Street Journal and George Selgin on the Alt-M blog. Congdon says that “history suggests the U.S. will soon see an inflation boom.” Selgin says that “[I]f denying any risk of future inflation is unwise, so is exaggerating that risk, or claiming that it’s imminent when it isn’t.” Selgin quotes Olivier Blanchard as saying that the risk of inflation is “very small.”

In fact there is reason to be concerned that Federal Reserve policies will not work out so well this time.

The money stock increased substantially in March and April 2020One way of assessing future inflation is the quantity of money in the United States. Figure 1 shows that the money stock, M2, has increased substantially, even relative to the increase in the Financial Crisis of 2007-2009. Inflation, which loosely speaking results from “too much money chasing too few goods”, can result from more rapid growth of the money stock.

Lockdowns and stay-at-home orders and other disruptions associated with the coronavirus pandemic have reduced employment and output substantially. The size of the decreases remains to be seen but filings for unemployment insurance by roughly 30 million people in the United States certainly suggest a very large decrease in goods and services to be purchased by this larger stock of money. This decrease in goods and services available is likely to be temporary though, so it is the increase in the money stock that is a longer-term concern.

Is recent money growth likely to continue? To the extent that the increase in M2 is associated with stimulus payments and unemployment payments, that source of increases in M2 probably will not continue for more than a few months.

The Federal Reserve, though, is on track to increase its balance sheet and reserves in the banking system substantially by buying financial assets and making loans to private firms. Purchases of financial assets are little different than the Federal Reserve’s policy since the Financial Crisis of 2007-2008. What is there to worry about?

The Federal Reserve has been operating a system in which it pays banks to hold reserves over and above required reserves. The Federal Reserve has used those excess reserves, which are deposits at the Fed, to acquire assets, long-term Treasury securities and mortgage-backed securities. Figure 2 shows that excess reserves increased substantially during the Fed’s policy of quantitative easing (QE) implemented in QE1, QE2 and QE3 visible in the graph.

Current policy proposes to increase reserves and asset holdings substantially more in the near future. The size of that increase is not certain, but the Treasury has provided credit protection and equity investments of $235 billion in the financial vehicles acquiring assets and making loans. Excess reserves increased by 90 percent from March 25, 2020 to April 22, 2020. It would not be particularly surprising if excess reserves reached twice the prior peak of $2.7 trillion. They already exceeded that prior peak by over 10 percent on April 22 and surely will exceed it by 25 to 50 percent ultimately.

The outsize increase in the Fed’s balance sheet during and after the Financial Crisis of 2007-2008 quite obviously had little or no effect on the M2 or on inflation. Are there reasons to think that conditions now are different?

A major concern is that banks may not want to hold the additional reserves in excess of requirements. Why not? About a third of these excess reserves are held by U.S. branches of foreign banks. These reserves satisfy a recently added requirement for banks: the liquidity coverage ratio. Reserves at the European Central Bank (ECB) also satisfy this requirement but the Federal Reserve pays interest for holding reserves at the Fed while the ECB charges interest for holding reserves at the ECB. There is foreign-exchange risk associated with holding dollars instead of euros, but that apparently does not deter foreign banks from holding liquidity at the Fed instead of the ECB. Large U.S. banks also are subject to the liquidity coverage ratio.

Is the demand for excess reserves unlimited? There is a major constraint on banks’ desire to hold excess reserves paying a relatively low interest rate. That constraint is a required leverage ratio imposed by banking regulations. The leverage ratio is a minimum requirement of equity capital in a bank relative to assets. Expansion of assets by acquiring excess reserves eventually runs into the leverage ratio, at which point equity capital would have to be issued to satisfy the required leverage ratio and increase holdings of reserves. Given the cost of capital and the interest rate on excess reserves, any bank doing this would be reducing the value of the bank to shareholders. In short, banks will eventually stop adding excess reserves.

If a bank doesn’t want to hold an increase in its excess reserves, what can it do when its excess reserves increase? Instead of holding the excess reserves, the bank can loan the money out or buy a security after holding reserves equal to a fraction of its increase in customer deposits. Other banks would do the same. Through the traditional multiple expansion of deposits, the money stock would, unlike in recent years, increase because excess reserves are increasing. If the Fed does not reduce excess reserves, an increase in the money stock ensues.

Such an increase in the money stock due to Fed policy would increase the dollar value of goods and services produced. Printing money does not increase production of goods and services for very long if ever. Increases in prices and inflation ensue.

The recent and prospective increases in excess reserves are different because the creation of excess reserves did not run into the leverage ratio. Without running into the leverage ratio, monetary policy from 2010 to 2020 could let the demand for money determine the quantity of money. With low expected inflation, the growth of money was consistent with that low expected inflation and in fact low inflation followed. If the Fed increases excess reserves and holds fast to those increases, inflation can result if banks no longer find it advantageous to hold those excess reserves.

How big is this risk? It is fair to say that no one knows. As recently as Spring 2019, the Fed was reducing excess reserves and found that banks wanted to hold a much higher level of excess reserves than expected. Similarly, the upper limit to how much excess reserves banks want to hold is uncertain.

Not knowing the relationship between monetary policy and inflation is a risky way to conduct monetary policy. Maybe everything will work out fine; maybe not.

What Is Essential?

The recent government lockdowns and stay-at-home orders are long on lists of things that are essential and not essential without defining or saying what determines whether something is essential or not essential.

What does “essential” mean? A synonym in the Merriam-Webster dictionary is “necessary.” “Necessary” has the advantage of being less vague. It also raises a question: “Necessary for what?”

A good example of the arbitrariness of government officials determining what is essential is a recent dust-up concerning wrestling in Florida. Florida has determined that sporting events, including wrestling matches, are essential. The headline and subheading on a negative editorial show the split: “His explanation doesn’t make much sense” reads the headline with DeSantis’s explanation that “I think people have been starved for content … we’re watching, like, reruns [of sporting events] from the early 2000s” under it.

The headline was written by a true non-sports fan. To those of us who watch little if any sports on television, sporting events are not only not essential, they’re not even interesting.

On the other hand, for those who like to watch sports, the drought of sporting events has in fact resulted in people watching long-ago reruns of run-of-the-mill events because, for them, it’s better than nothing. They would be a lot happier with new sporting events.

Why pick on wrestling in particular? It is easy to make snide comments about wrestling matches, and wrestling matches have started. While the order concerns sporting events generally, wrestling matches do have an advantage that team sports such as baseball do not. There are few people in a locker room before a wrestling match. Before sports such as baseball and football can resume, they have to resolve a basic problem: How does one deal with many athletes preparing for a game? Even eliminating the physical audience or limiting the stadium to a fraction of normal capacity will not resolve that problem. Also, most sports are contact sports and definitely are not “socially distant” games. Wrestlers are in close contact with few people compared to the typical lineman in a football game.

Are wrestling matches or more generally sports events necessary? If you are a sports fan stuck at home worrying about when your life will resume, maybe so. It might be better than hitting the bottle.

Leaving aside sports, what is necessary? One person’s essential or necessary is another person’s unimportant.

To some people, going to church is essential to their salvation. To some people, going to a church is a waste of time.

Are “elective surgeries” essential? The shutdown of hospitals’ non-essential services, which includes bypass surgery, may already have increased deaths due to this apparently not-so-immediate ailment.

Is a lawn service necessary? If you don’t own a lawnmower because you employ a lawn service and can afford it, buying a lawnmower – if you can because lawnmowers are “essential” – is an expensive stopgap. Letting your lawn grow for a few weeks, a month or maybe longer might not be very attractive but might be the best thing to do. The worst part of declaring lawn services non-essential: Shutting them down in the name of “social distancing” reflects ignorance about how lawn services work. The workers mow the yard, do some trimming and leave. They are nowhere near the homeowner and not even close to each other besides in the truck.

Part of the argument for shutting down “non-essential” activities is that it is better to have fewer people going to work. This may have been a plausible argument while “flattening the curve.” It misses an important problem beyond that time frame.

It will take a year or more to create and produce a reliable vaccine in the quantity necessary for the United States. In the meantime, every activity accomplished with a stranger will involve the risk that the other person has coronavirus. Besides keeping most people in the U.S. at home until a vaccine is found for the coronavirus, the risk of contracting coronavirus while engaging in everyday activities will be a fact of life.

Taking care can limit the risk of contracting coronavirus. Wearing a mask might be a way to assure people that you are trying to avoid spreading coronavirus to them should you have it. Widespread and readily available testing can limit the risk because people will know whether or not they have coronavirus. Government edicts about “essential” and “not essential” activities are no help.