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Not buying one argument for short-term inflation danger [ClearOnMoney]
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Not buying one argument for short-term inflation danger

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Commentary

Not buying one argument for short-term inflation danger

11 Apr 2011 by Jim Fickett.

John Hussman thinks there is some short-term inflation danger from the Fed working in an unstable area of monetary policy. Although it does worry me that the Fed is in uncharted territory, I do not think the particular argument holds water.

I'm worried about inflation in the long run. I don't think the danger is near yet, but it is hard to be sure. When I see an argument from a sensible person for near-term danger, therefore, I try to understand it. John Hussman has recently made such an argument, in two related posts.

The first was on 24 Jan, entitled, Sixteen Cents: Pushing the Unstable Limits of Monetary Policy:

One of the best known relationships in economics is the concept of “liquidity preference” - essentially money demand. Both theoretically and in actual data, there is a fairly tight relationship between short-term interest rates, and the amount of non-interest-bearing money that people are willing to hold, either directly as currency, or indirectly as bank reserves. Basically, the lower interest rates are, the more cash or reserves (“base money”) people are willing to carry around, per dollar of nominal GDP. As interest rates move higher, people naturally respond to the opportunity to earn interest by reducing the amount of cash they carry, both directly and indirectly.

[Emphasis added]

Base money is defined as cash plus bank reserves, and liquidity preference is the amount of base money, expressed as a fraction of nominal GDP. Intuitively, the relationship between liquidity preference and interest rates is based on the idea that base money is non-interest-bearing. This has been true historically, but since October of 2008 the Fed has been paying interest on bank reserves (see footnote), exactly because they do not want other uses of the money to compete. This means we cannot place too much weight on historical data when trying to guess present outcomes.

Hussman works with two main equations. One is the definition of liquidity preference:

LiquidityPreference = MonetaryBase/NominalGDP

The other is a purely empirical relationship, derived from historical data:

LiquidityPreference = .094 - .022 * log(3MonthTBillRate)

We can compare these two, the actual liquidity preference, and a model that predicts it based on the 3-month T-bill rate:

The two are obviously highly correlated, but also diverge significantly at times. Hussman also gives a more elaborate modeled value for liquidity preference, but it is not relevant to the inflation discussion, so I'll leave it aside.

Now we can get to inflation. If we combine the above two equations, separate nominal GDP into real GDP and the GDP deflator, and take the latter as an indication of inflation, we get

Inflation = GDPDeflator = MonetaryBase/(RealGDP)*(.094 - .022*log(3MonthTBillRate))

In the January post, and then in another post today, Hussman then goes through a number of examples of what might happen to inflation if the 3 month T-bill rate were to rise, or how the monetary base would have to contract to prevent inflation. There are two problems with trying to take such reasoning very far. First, the empirical relationship between interest rates and liquidity preference is based on data before the Federal Reserve started paying interest on bank reserves. It is not at all clear that it will continue to hold. And second, even with the historical data, the empirical relationship can break down for long periods.

The main intuitive idea behind the whole argument is that

In order to prevent inflationary impact from this level of monetary base (that is, to prevent base money from becoming a “hot potato” that nobody is willing to hold), we estimate that 3-month Treasury bill yields will have to be sustained no higher than a few basis points until the Fed reverses course.

The “hot potato” argument is spurious. The whole point of the Fed paying interest on bank reserves is that it makes holding the base money attractive again, even in the face of competing uses. Currently, the interest on reserves is 0.25%, while the 3-month T-bill rate is 0.04%. Clearly the T-bill rate did not have to go that low in order to avoid tempting money away from reserves paying 0.25%.

I agree with Hussman's most fundamental concern, that the Fed is in uncharted territory and using tools whose risks are unknown. But rather than being worried about this particular relationship between short-term interest rates and inflation, I am more worried about the politics of the Fed trying to withdraw support when it needs to. Suppose that at some point the bond markets began to worry about whether US debt will ever be repaid, and hence interest rates begin to rise. Then the Fed, conflicted by its dual mandate, will be forced to choose between allowing the higher rates, and hence seeing rising unemployment, or monetizing the debt, and likely bringing on inflation. Even for a fully independent central bank, that would not be an easy choice. But for the Federal Reserve, which has cast itself as a team player with the administration in rescuing the economy, it would be very tough to take the hard line.

Footnote: Federal Reserve interest payments on bank reserves

The Federal Reserve announced a new policy of paying interest on reserves on 6 Oct 2008, and then adjusted the rules on 22 Oct and 5 Nov. A history of the interest paid on reserves shows considerable fluctuation from inititialization in 15 Oct 2008 to 17 Dec 2008, but then 0.25% on both required and excess reserves, from 24 Dec 2008 to the present.