Today’s objective is to explain Mike Moffat’s recent article
in the Globe and Mail. First, some definitions: Hyperinflation is a period of rapid, broad-based price increases,
normally defined as inflation in excess of 50% per month. The monetary base is the liability of the
central bank. This typically consists of issued currency plus reserve deposits
of commercial banks. The money supply
(M2) consists of currency in circulation (in the hands of the non-bank public)
plus chequing and savings accounts at commercial banks and credit unions plus
money market mutual funds. M2 is ‘money’ as a medium of exchange.
The Quantity Theory of Money tells us that there is a relationship
between the money supply and prices. More specifically; the inflation rate will
be equal to the growth rate of the money supply minus the growth rate of real
GDP (gross domestic product).
The journalists and commentators that are predicting hyperinflation
as a result of the Fed’s loose monetary policy are confusing the money supply
with the monetary base. To maintain liquidity in the commercial banks, the Fed
has been purchasing money market instruments – short term treasury bills and
commercial paper off the market and paying for them with newly created reserve
deposits. This action causes an increase in the monetary base. The commercial
banks lost billions in the financial collapse and are still fighting liquidity
problems. As a result, they have been increasing their reserves. When banks
hold reserves and don’t lend them out, the monetary base increases, but the
money supply does not. Inflation is caused by an increase in the money supply,
not the monetary base. Until banks start lending these reserves, there is very
little threat of inflation.
The Globe and Mail article suggests that the markets
understand this even if the journalists don’t. The Fisher equation tells us
that the nominal interest (the interest rate measured in dollars) is approximately
equal to the real interest rate (purchasing power) plus the expected rate of
inflation. Nominal rates for 10-yr treasuries are just under 2% at the time of
writing. This implies that money market professionals do not expect to see
inflation in the near future, regardless of what the commentators say.
At a dinner hosted by the Boston Fed last May, it was
apparent that officials in the US are aware of the buildup in reserves and do
actually have a plan to prevent inflation in the event that lending activity
increases.
Until then, just remember, the sky is not falling … except in Russia.
