Download Why the Fed`s $4.1 trillion balance sheet isn`t creating inflation

Why the Fed’s $4.1 trillion balance sheet
isn’t creating inflation
Market Outlook | March 2014
merchandise is the velocity. In order to double the number
of parcels delivered one can either double the number
of trucks, double their delivery speed or a combination
of both. Velocity is assumed to be roughly constant by
monetarists. This relationship between money supply, its
velocity and the dollar value of GDP is not controversial
because it is an identity and therefore must always hold
in hindsight. However, concluding from it that the Fed’s
balance sheet expansion must automatically lead to high
inflation is problematic on several counts:
In spite of the IMF’s recent warning about reemerging
deflationary risk, especially in the eurozone, a recurring
question in many client conversations is: Why hasn’t
US inflation reared its ugly head following the massive
injection of Fed liquidity of about USD 3.2 trillion since
Lehman’s collapse? The notion that inflation should
be much higher than the paltry 1.6% recorded in the
Consumer Price Index (CPI) in January emanates from
the deeply entrenched monetarist school of thought
exemplified by its founder, the late Milton Friedman,
and his claim that “inflation is always and everywhere
a monetary phenomenon.” By clarifying the monetarist
framework, its key assumptions and some popular
misconceptions about it, we explain why this simple rule
of thumb has not been useful to understand the path of
inflation in this cycle.
To make our point, we start with the monetarist
framework, which relies on a classic relationship that links
the money supply to the dollar value of Gross Domestic
Product (GDP). The latter captures both the quantity of
goods and services produced in the economy and their
price level. The key is to understand that the missing link
between money supply and GDP is the speed at which
the money supply is turned over to generate purchases
of goods and services. Economists call this turnover rate
the velocity of money. The velocity of money can be
thought of as the number of times a dollar in circulation
is used in transactions during a given period. To illustrate
this relationship, think of a courier service. The number
of packages corresponds to GDP, the fleet of vehicles is
money supply and the speed at which the trucks deliver
First, an important misconception concerns the right
measure of money supply. The money supply the Fed
controls directly by expanding its balance sheet is called
central bank money (or M0) and represents currency in
circulation (all bank notes and coins) and bank reserves
held at the Fed. It is not the money supply concept used
in the monetarist framework. Economists usually rely
on broader monetary aggregates (called M1 or M2),
which include checking and savings accounts and which
therefore represent the money supply in the broader
financial system to which not only banks but also
businesses and consumers have access. They therefore
have a much stronger connection with GDP. During the
Great Recession, the massive credit crunch that affected
the financial system broke the usual link between central
bank money and broader monetary aggregates. So while
the Fed has pumped about USD 3.2 trillion into the
banking system, M1 and M2 have grown at a much more
moderate pace (see Fig. 1), suggesting a much tamer
inflation outlook than M0 would.
Second, a key assumption made by monetarists is that
the velocity of money is stable or fairly constant over
time. In practice, this is not the case. In fact, money
velocity has fallen from about 2 before the Great
Recession to about 1.6 recently, a 20% reduction (see
Fig. 2). Therefore, over this period we have in effect
seen a 20% deflationary shock that helps absorb the
growth in money supply, as a constant money supply
would have led to a 20% decrease in purchases of
goods and services over a comparable time period. The
decline in the velocity of money is largely a result of the
credit crunch in the financial system as businesses and
consumers struggled to obtain financing for purchases.
This credit crunch is still in the process of resolving itself.
Third, monetarists believed that the increase in money
supply would eventually show up in a proportionate
increase in the prices of goods and services, as it was
unlikely to provide a lasting boost to the quantities of
goods and services produced or real GDP. The implicit
assumption behind this claim is that the economy
was already operating close to full capacity or full
employment, so that any stimulation of aggregate
demand would hit capacity constraints and lead to
price increases rather than an increase in real GDP.
But the depth of the Great Recession has left the US
economy operating well below its long-run potential.
The Congressional Budget Office estimates that the US
economy is currently operating about 3.8% below its
potential, the largest gap since the 1980s, excluding
the recent recession. This is crucial, since price pressures
cannot easily emerge when the economy is operating
far below potential. Under such circumstances, the
rational response by businesses to accelerating consumer
demand is to increase production and gain market
share, not to increase prices.
The link between the clogged credit system, the
abundant slack in resource utilization (labor and capital)
and low inflation is well understood by the Fed. This
is why the Fed was emboldened to embark on QE3,
why its exit strategy is a slow and gradual one and
why the first rate hike in this cycle is unlikely to happen
before mid-2015. From an investment perspective, this
supports our preference for stocks over bonds over
a tactical horizon. The mere fact that we are in the
process of exiting ultra-loose monetary policy suggests
that Treasury bond yields will continue to rise over the
next 12 months, creating pressure across bond markets.
However, without any significant inflation risk, the
prospect for a massive sell-off in bonds appears very
limited. For equities, on the other hand, an accelerating
economy combined with a slow Fed exit creates a
sweet spot for this asset class. With valuations now
at their historical average levels, investors should not
count on equities becoming more expensive via multiple
expansions as the key driver of returns, as was the case
in 2013. However, with earnings likely to grow at about
8% this year, even flat valuations should allow equities
to outperform bonds and cash.
Let’s talk about it
The above was taken from CIO Wealth Management
Research’s UBS House View: Investment Strategy Guide
(March 2014). To obtain a copy of this report and discuss
how its research insights can help you make better
investment decisions, please contact a UBS Financial
Advisor.
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