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					Northern Trust             If Inflation Is a Monetary Phenomenon, Is U.S. Hyperinflation a Clear and Present
Global Economic Research
50 South LaSalle           Danger?
Chicago, Illinois 60603    August 19, 2009
northerntrust.com
                           We hear a lot of concern that the Fed’s mushroomed balance sheet over the past two years is
                           setting the stage for a 1970s’ style inflation here. So long as we have a fiat (a.k.a. Chrysler?)
                           monetary standard, the threat of hyperinflation always lurks. But is the stage currently being set
Paul L. Kasriel
plk1@ntrs.com
                           for such an eventuality? I do not think so.

                           Chart 1 shows the behavior of changes in the M2 money supply over the past 50 years on a year-
                           over-year basis. After the Lehman crisis in the summer of 2008, M2 growth accelerated sharply.
                           By January 2009, the year-over-year growth in M2 reached 10.1%. Although not quite matching
                           the 13-1/2% M2 growth often reached in the 1970s, if sustained, 10% M2 growth certainly would
                           have the potential to push inflation significantly higher. Although the year-over-year growth in
                           M2 has decelerated to 8.4% in July, that rate of growth if sustained, could still pack plenty of
                           inflationary punch. So, why am I still not worked up about the potential for a 1970s’ style of
                           inflation?

                                                                                          Chart 1
                                                                                  Money Stock: M2

                                                                         % Change - Year to Year            NSA, Bil. $

                                          15. 0                                                                                     15. 0



                                          12. 5                                                                                     12. 5



                                          10. 0                                                                                     10. 0



                                           7. 5                                                                                      7. 5



                                           5. 0                                                                                      5. 0



                                           2. 5                                                                                      2. 5



                                           0. 0                                                                                      0. 0
                                                   60       65      70      75       80      85        90         95      00   05
                                                  Sour ce: Feder al Reser ve Boar d /Haver Analytics



                           Take a look at Chart 2, which plots the behavior of the M2 money supply on a six-month
                           annualized basis. After the spike to 15.2% annualized growth in February of this year, in the six
                           months ended July, annualized M2 growth was only 2.7%. Barring another surge in M2 growth,
                           this sharp six-month deceleration in M2 growth implies a continued deceleration in year-over-
                           year M2 growth and, thus, a reduced likelihood of a repeat of the 1970s high-inflation
                           environment.
                           The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust
                           Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein,
                           such information is subject to change and is not intended to influence your investment decisions.
                                                              Chart 2
                                                      Money Stock: M2

                                               6-month %Change-ann         SA, Bil. $

                20                                                                                  20



                16                                                                                  16



                12                                                                                  12



                  8                                                                                 8



                  4                                                                                 4



                  0                                                                                 0



                 -4                                                                                 -4
                       60       65      70      75       80      85        90       95   00   05
                      Sour ce: Feder al Reser ve Boar d /Haver Analytics




How is it that the explosion in assets on the Fed’s balance sheet from approximately $901 billion
at the end of July 2007 to approximately $2 trillion at the end of July 2009 (see Chart 3) has not
resulted in a sustained explosion in M2 money supply growth? Because of the extraordinary
increase in excess, or idle, cash reserves on the books of banks. As shown in Chart 4, banks’
excess reserves soared from only $1.6 billion in July 2007 to almost $733 billion in July 2009. So,
about 64% of the increase in Fed assets in the two years ended July 2009 was accounted for by
the increase in idle cash reserves sitting on the books of banks. A further 8.5% of the two-year
increase in Fed assets was accounted for by an increase in currency in our pockets and/or
squirreled away in our safe deposit boxes (see Chart 5). This dramatic increase in the demand for
“folding money” was likely the result of an extreme case of risk aversion rather than a preparation
for a shopping splurge (other than for canned goods and ammo, perhaps).




The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust
Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein,
such information is subject to change and is not intended to influence your investment decisions.

                                                                                                                         2
                                                            Chart 3
                                        Total Factor s Supplying Reser ve Funds

                                                           EOP, Mil. $

           2400000                                                                                  2400000



           2000000                                                                                  2000000



           1600000                                                                                  1600000



           1200000                                                                                  1200000



            800000                                                                                  800000



            400000                                                                                  400000



                  0                                                                                 0
                            90                  95                  00           05
                      Sour ce: Feder al Reser ve Boar d /Haver Analytics



                                                            Chart 4

                                Adjusted Excess Reser ves of Depositor y Institutions

                                                           NSA, Mil. $

           1000000                                                                                  1000000




            800000                                                                                  800000




            600000                                                                                  600000




            400000                                                                                  400000




            200000                                                                                  200000




                  0                                                                                 0
                      90                    95                    00            05
                      Sour ce: Feder al Reser ve Boar d /Haver Analytics




The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust
Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein,
such information is subject to change and is not intended to influence your investment decisions.

                                                                                                                         3
                                                                 Chart 5
                                  Factor s Absor bing Reser ve Funds: Cur r ency in Cir culation

                                                       24- month Change     EOP, Mil. $

                   120000                                                                                           120000




                   100000                                                                                           100000




                    80000                                                                                           80000




                    60000                                                                                           60000




                    40000                                                                                           40000




                    20000                                                                                           20000
                                     03          04           05         06           07        08             09
                            Sour ce: Feder al Reser ve Boar d /Haver Analytics




Why have banks allowed idle cash reserves to pile up on their balance sheets? Several reasons.
For starters, the Fed now pays them a nominal rate of interest to hold these idle reserves. But this
is not the main cause of soaring excess reserves. The principal reasons are lack of capital and lack
of demand from borrowers who might be able to stay current on loans. The banking system has
experienced sharp losses in the past year and is about to experience a second wave of losses.
These losses deplete bank capital. Without adequate capital, the banking system cannot create
new credit. At the same time that banks are strapped for capital, they also are strapped for loan
customers who are judged creditworthy (see Chart 6).

                                                                 Chart 6
                              FRB Sr Off Sur vey: Banks Repor ting Str onger Demand for Consumer Loans (%)
                              FRB Sr Loan Off Sur vey: Repor ting Str onger Demand for Comml Real Estate (%)
                               FRB Sr Off Sur vey: Banks Rpr tg Str onger Demand for C&I Loans/Lg Fir ms (%)


                       50                                                                                           50




                       25                                                                                           25




                        0                                                                                           0




                      -25                                                                                           - 25




                      -50                                                                                           - 50




                      -75                                                                                           - 75
                                           06                   07                   08                  09
                            Sour ce: Feder al Reser ve Boar d /Haver Analytics


The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust
Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein,
such information is subject to change and is not intended to influence your investment decisions.

                                                                                                                             4
But, a year from now, the banking system is likely to be better capitalized and the demand for
bank credit from creditworthy borrowers is likely to be rising. This is when we will have to start
to be more concerned about that mountain of excess reserves sitting on the books of banks being
“activated” to create new credit to the nonbank sector. If the Fed does not take steps to adequately
neutralize these excess reserves, then the inflationary game will be on. I do not currently know
how adroit the Fed will be in neutralizing excess reserves. Evidently those who are forecasting a
return to 1970s style inflation do know. More power to them.




The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust
Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein,
such information is subject to change and is not intended to influence your investment decisions.

                                                                                                                         5

				
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