Sunday, April 5, 2009

Balance sheet expansions and inflationary expectations

Over the last few months, in its efforts to unlock the frozen cedit markets and help banks "deleverage in an orderly manner", the Fed has expanded its balance sheet dramatically, by almost three times, and "intervening on Wall Street in ways never before contemplated by the Fed". In many respects, by resorting to printing money in massive quantities, the Fed has emerged as the banker to the US and even world economy, a lender, insurer and investor of last resort.

However, the sweeping extent of monetary loosening and expansion of credit using these unconventional monetary policy techniques like "quantitative easing" by the US Federal Reserve, while required given the extraordinary challenge being faced, does raise serious concerns about the future. James Kwak and Simon Johnson now claim that these actions could unleash the most serious bout of inflation in the US since early 1980s. They feel that Bernanke is "making the biggest bet placed by a US central banker in decades, wagering that he can pull the economy out of a deep crisis by creating money without unleashing high and long-lasting inflation".

Faced with the prospect of deflation (especially dangerous ina debt-laden economy, since it increases the real burden of debt), the Fed announced its decision to purchase long term Treasuries in the open market, with newly printed money (which reduces the value of each dollar in circulation and therefore raises the dollar price of goods and services), so as to push down long-term interest rates (by increasing the amount of money available for long-term lending) and thereby both stimulate borrowing and greater spending, and more importantly raise expectations about future inflation. This is in keeping with Bernanke's well known opinion that Fed could prevent deflation by printing money, "Under a paper-money system, a determined government can always generate higher spending and hence positive inflation".

Kwak and Johnson argue that the US economy is increasingly exhibiting characteristics of emerging economies, where the presence ofeconomic "slack" (it is thought as long as the economy is underperforming stimulating the economy will only cause that "slack" to be taken up) does not prevent economies slipping into the inflation territory. They write,

"We seem to have taken on some features of so-called emerging markets, including a bloated (and contracting) financial sector, overly indebted consumers, and firms that are trying hard to save cash by investing less. In emerging markets there is no meaningful idea of "slack"; there can be high inflation even when the economy is contracting or when growth is considerably lower than in the recent past.

If the United States is indeed behaving more like an emerging market, inflation is far easier to manufacture. People quickly become dubious of the value of money and shift into goods and foreign currencies more readily. Large budget deficits also directly raise inflation expectations. This would help Bernanke avoid deflation, but there is a great danger that unstable inflation expectations will become self-fulfilling. We do not want to become more like Argentina in 2001-2002 or Russia in 1998, when currencies collapsed and inflation soared."

In this context, Mark Thoma makes the important point that the only thing standing in the way of run-away inflation or atleast inflationary expectations is the credibility of Central Bankers. There have been a number of analyses which have claimed that unlike in the past, inflation expectations are more justifiably anchored today, since most stakeholders believe that the "Fed is committed to preventing an outburst of inflation, and that they are capable of carrying through on that commitment". John Williams of Federal Reserve Bank of San Francisco (full text here) has written that, given the amount of slack present in the economy, if inflation expectations now are "unanchored," then we should be worried about deflation.

Mark Thoma also points to Tim Duy, who feels that since the Fed is clearly committing itself to temporary increase in money supply, inflationary expectations are well anchored. Unlike Kwak and Johnson, who feel that Bernanke is resorting to unconventional monetary policy responses to raise inflationary expectations (so as to counter deflation), Duy claims that Bernanke's main objective is only to ease the credit markets through a temporary monetary easing. He feels that only if the Fed loses control and political pressures force the Fed to keep the increase in credit supply more than temporary, will inflationary pressures get out of control.

David Altig of the Federal Reserve of Atlanta, draws the critical distinction between loosening monetary policy through quantitative easing and credit policy easing by purchasing toxic assets. He argues that the recent decision by the Fed to further expand its balance sheet by up to $1.15 trillion (by buying up illiquid assets through the PPIP and the TALF, leveraging debt from the Treasury and the FDIC and equity from the TARP) is not a case of QE, but an attempt at temporary "credit easing", as described by Bernanke himself.

Both involve expansion of the Fed's balance sheet. However there are crucial differences in the focus of the two expansions. QE seeks to put assets into the economy that increase the money supply and to that extent focuses merely on the quantity of bank reserves (and the composition of loans and securities on the asset side of the central bank's balance sheet is incidental), which are liabilities of the central bank. In contrast, credit easing or credit policy focuses on the quality of the assets side. With credit easing, the primary focus is on the assets side - ie., on the composition of loans and securities on the asset side.

Update 1
More by Tim Duy on the Fed's policy of committing to anchor inflationary expectations here.

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