The Sweet Smell of Inflation, or, Never Trust Anybody Who Says "Nascent"

Dream sweetly, Americans, in your cardboard tents. With a sure hand on the tiller, Ben Bernanke is steering us through the night. Today, the chairman of the Federal Reserve Bank sent forth a dove to find the shore inflation, and the dove returned, and Bernanke saw that it was good, and verily he raised the Fed's discount rate from 0.5 percent to 0.75 percent.

This is the discount rate, which the Fed charges to banks that borrow money from its reserve balances. The more closely watched Fed funds rate, which banks charge each other to borrow from the Fed's reserves, is unchanged at 0 to 1/4 percent.

If you're a Fed believer, you may say this is an example of the kind of "careful policy choices" Federal Reserve Bank of Minneapolis President Narayana R. Kocherlakota promised in a popular speech this week. Addressing the Minnesota Bankers Association, Kocherlakota stopped just short of calling the nascent recovery inchoate: 

[E]ven very bad recessions do come to an end. There is a nascent recovery under way. As I will describe, I expect it to continue. However, my own forecast is that the recovery in GDP and especially unemployment will be slow because of uncertainties relating to various legislative initiatives and problems in the banking sector. I do think the news is mostly good on the inflation front, although the need for careful policy choices is even more critical than usual.

Why do I say that a recovery is under way? Real GDP began to grow again in the third quarter of 2009. In fact, that growth rate accelerated to a seasonally adjusted annualized rate of 5.7 percent in the fourth quarter. My own prediction is that the National Bureau of Economic Research will declare this recession to have ended sometime in the second half of last year. However, GDP is not the whole story. It is true that, as measured by unemployment, the economy is still stuck in a trough. I will have more to say about that in a few minutes.

Kocherlakota has an interesting discussion of the vast number of newly created dollars banks are holding in reserve. But he doesn't mention that one of the reasons banks are holding so much cash is that the Fed is paying them interest on it. This experiment in monetary policy is being conducted under the Financial Services Regulatory Relief Act of 2006, which authorized the Fed "to begin paying interest on balances held by or on behalf of depository institutions beginning October 1, 2011." The Emergency Economic Stabilization Act of 2008 (now more commonly known as the "bailout" or "TARP") made the start date retroactive to October 1, 2008. This allows the Fed to create trillions of new dollars without having the effects be immediately detectable in the nation's wheelbarrows.

But how long can it go on? Kocherlakota says the outlook for inflation is "basically promising," but then explains how unlikely it is that the return to fractional-reserve lending will happen in an orderly manner:

Deposit institutions are holding over a trillion dollars of excess reserves (that is, over 15 times what they are required to hold given their deposits). These excess reserves create the potential for high inflation. Suppose that households believe that prices will rise. They would then demand more deposits to use for transactions. Banks can readily accommodate this extra demand, because they are holding so many excess reserves. These extra deposits become extra money chasing the same amount of goods and so generate upward pressure on prices. The households’ inflationary expectations would, in fact, become self-fulfilling.

Why might households expect an increase in inflation? The amount of federal government debt held by the private sector has gone up by over 30 percent since the beginning of 2008. This debt can only be paid by tax collections or by the Federal Reserve’s debt monetization (that is, by printing dollars to pay off the obligations incurred by Congress). If households begin to expect that the latter will be true—even if it is not—their inflationary expectations will rise as well.

I hasten to say—and I want to stress—that I view this scenario as unlikely.

Of course you do, Narayana, of course you do.

This Nasdaq summary of the Fed's moves today is a must read, and includes a reminder that the recovery is only latently nascent:

[T]he more modest 0.3 percent rise in PPI excluding food and energy prices indicate that inflationary pressures stemmed primarily from higher gasoline and energy costs. Evidence of lower prices on women's apparel, passenger cars and computers indicates that weak consumer demand is still holding back price growth in other parts of the economy.

Bernanke's major academic work is on the Great Depression, so his attitude toward inflation stems from a core belief that those nations which inflated first were the first to recover. He spent most of the seventies and early eighties playing bass in Olivia Newton-John's touring band, and his studies of the Ford-Carter-Reagan era were less thorough as a result. (And his thesis on the G.W. Bush era is totally insane.) So I'd just like to remind him: Stagflation exists, and it is American.

Speaking of which, does anybody remember certificates of deposit? I mean, they still exist, but does anybody remember when they were the only decent place to put your money?

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  • ||

    "But he doesn't mention that one of the reasons banks are holding so much cash is that the Fed is paying them interest on it. This experiment in monetary policy is being conducted under the Financial Services Regulatory Relief Act of 2006,"
    AFAIK, no one is yet predicting the result of this; those I've spoken with are sort of 'peering intently' and waiting.
    It's not directly inflationary, in that it's profitable to keep it as reserves. But, indirectly, it releases what currency would have been kept as reserve.
    So it *is* inflationary to some degree.
    It also adds to the interest costs of the national debt, in spite of the fact that it's *not* debt.

  • ||

    I agree with the comment but think it's important to emphasize that the reason it is profitable for the banks to hold reserves is because they invest those reserves in treasury securities paying a much higher interest rate than they pay to borrow from the Fed. Theoretically, they take on interest rate risk but with Ben and the boys in their pockets, the banks can feel pretty secure that they are picking up nearly riskless money.

    Given the choice between a proftable but virtually riskless investment in treasuries or lending to corporations and individuals who may go tits up, which do you think they choose?

  • ||

    JR, the government is *paying* interest to the banks which 'borrow' the money.
    So any investment income is in addition to the interest they're already being paid.

  • ||

    It is called staflation. And it happens everytime liberals are left in charge of fiscal policy without adult supervision

  • Old Mexican||

    Dream sweetly, Americans, in your cardboard tents.

    Obamavilles . . . has a nice ring to it.

  • RCTL||

    Do I trust the guy who uses nascent thrice?

  • ||

    Dude this is like the craziest thign I ever seen dude. Well done.

    Jess
    www.privacy-tools.de.tc

  • ||

    How 'bout trusting a guy that says "Dude" twice in the same sentence? I mean yeah, it's the anonimity bot, but is this more evidence that it can't be trusted?

  • she's a lady||

    I think the guy is a girl with a wicked sense of humor.

  • Old Mexican||

    [E]ven very bad recessions do come to an end.

    No . . . . way!

    This guy is a veritable genius.

    There is a nascent recovery under way. As I will describe, I expect it to continue.

    There's a nascent pain in my butt, and I expect it to continue.

    However, my own forecast is that the recovery in GDP and especially unemployment will be slow because of uncertainties relating to various legislative initiatives and problems in the banking sector.

    Forget about the despoiling of our savings, the debasement of our currency, and the fact that the government is populated by fascists . . . the problem is really legislative gridlock and banks that don't lend. Huh.

    I do think the news is mostly good on the inflation front

    At least, for daddy Inflation and Mrs. Inflation...

    although the need for careful policy choices is even more critical than usual.

    Translation: The FED will have to jack up interest rates, but I don't want to say that out loud.

    Why do I say that a recovery is under way?

    Hmmm . . . because you are an economics-illiterate fool?

    Real GDP began to grow again in the third quarter of 2009. In fact, that growth rate accelerated to a seasonally adjusted annualized rate of 5.7 percent in the fourth quarter.

    Well, let's open the Champagne - uh, how much of that GDP comes from ACTUAL productivity?

    I didn't think so.

    My own prediction is that the National Bureau of Economic Research will declare this recession to have ended sometime in the second half of last year. [sic]

    My predictions are always done in hindsight.


    However, GDP is not the whole story. It is true that, as measured by unemployment, the economy is still stuck in a trough.

    And measured my actual productivity, it is in a very BIG trough.

  • RCTL||

    OM, "There's a nascent pain in my butt, and I expect it to continue." Did you not read the headline or was this a subtle joke?

  • Old Mexican||

    Hey, RCTL,

    Did you read how he predicts what will happen last year?

  • TP||

    ... but I don't want to say that out loud.

    Yeah, right? Nobody does, but everybody knows it's coming.

  • Old Mexican||

    [T]he more modest 0.3 percent rise in PPI excluding food and energy prices indicate that inflationary pressures stemmed primarily from higher gasoline and energy costs.

    Cracks me up when supposed experts confuse increases in price due to higher demand with inflation. Not that there's no inflation (there IS), but inflation is not the increase in prices; it is the CONTINUOUS increase in the money supply.

  • cmace||

    Paying money on reserves is deflationary, it encourages the banks to hold more reserve instead of loaning it.

    "These excess reserves create the potential for high inflation. Suppose that households believe that prices will rise. They would then demand more deposits to use for transactions."

    They can demand all they want. The banks are making money doing nothing. Why would they loan it?

  • ||

    Well. money's fungible. They cover the required reserves with that new M-.5, loan what used to be M-1.

  • Russ 2000||

    He meant taking money out of their demand deposit accounts. (It confused me too, but he's a banker so he doesn't know he's not speaking normal English.)

  • ||

    Remember the Misery Index? Take a look at where it is today!
    http://www.miseryindex.us/

    http://www.miseryindex.us/customindexoneyear.asp

  • cmace||

    (whoops)During the recession of the early '80s inflation continued. Thus real wages were reduced, employers hired. The deflation of the current recession is what will keep unemployment high.

  • Alan Vanneman||

    "I mean, they still exist, but does anybody remember when they were the only decent place to put your money?"

    I sure don't, because they never were. Put your money (most of it) in stocks.

    By the way, Greg Mankiw, that damn hippie, thinks we could use a dose of inflation to get things cooking.

  • OMG||

    And here right on display is Bernanke's plan in action. The zero interest rate policy is the greatest regressive transfer of wealth in the history of this country - ripping the yield away from savers and retirees in order to (i) inflate the stock market (why put your money in a CD paying less than 1% a year, "Put your money (most of it) in stocks.") and (ii) recapitalize the banks through a steep yield curve

  • ||

    And retirees just have to take it in the ass, as they need a steady income stream, and can't afford the volatility of the market.

  • ||

    Yeah, why keep your money in T-bills earning 0% when you could lose 30 or 40% in the stock market?

  • OMG||

    +1

  • Russ 2000||

    Remind me not to take financial advice from film critics.

  • ||

    I kind of agree but the fact is that many look at it as they can't afford to park money in safe place (bank, CD) and get 1%. They feel they must put it into something that pays a yield (which means taking on risk). This is what fed wants anyway - compel people to buy risky assets to prop up their value. Ponzi/leverage schemes fall apart when investors pull their money or investment values fall.

  • mark||

    I thought Greg Mankiw advocated negative interest rates, i.e. 10% of FRN's with a serial number ending in X are expired each year. Thus you can borrow at 0% but you have to spend it or you lose money.

  • mark||

    Actually that sounds pretty inflationary now that I think about it.

  • ||

    stopped just short of calling the nascent recovery inchoate

    That's some classic Cavanaugh right there. Plus one, my good man. Plus one.

  • Dan Lavatan||

    Saying consumer's "expect" prices to increase doesn't make any sense. Prices are what they are when consumers consume. We direct the banks to pay for things only at that time, which is why we use banks.

  • Sam Grove||

    Bernanke's major academic work is on the Great Depression, so his attitude toward inflation stems from a core belief that those nations which inflated first were the first to recover.

    Does he also believe that the depression ended with U.S. entry into WWII?

  • John Maynard Keynes||

    Tim, that was a lucid, well thought-out argument. OVERRULED!!!

  • ||

    Mr. Cavanaugh: Couldn't you find a different link for the wheelbarrow pic?

    I just threw up a little in my mouth.

  • ||

    agreed - there are plenty of places you can find that pic, Tim, without having to link to a Jew-hater

  • ||

    If you go back and read Greenspan's early academic work, it invokes sadness for someone who whored himself so completely just to be the Grand Poobah of the Fed.

    Of course, just like with Ole Yeller and his rabies, I would brush away the tear just before pulling the trigger.

  • ||

    [E]ven very bad recessions do come to an end.

    Tell that to the Romans.

  • ||

    one of the reasons banks are holding so much cash is that the Fed is paying them interest on it.

    You have to be fucking joking.

  • ||

    The banks are holding cash because there are almost zero creditworthy borrowers left in the country, and they know that most of the second-lien, HELOC, option ARM crap they've got on their books backing their depositors' checking accounts are actually just worthless pieces of paper.

  • OMG||

    No. Sadly it is all QFT

  • ||

    Your both right. Banks are getting paid to buy treasuries with money they borrow from the govt at virtually no cost. Nice work if you can get it. Because the fed wants their borrowing cost to be virtually zero, savers (retirees, etc.) get virtually zero on any riskless investment. Banks sit on treasuries and wait for profits to flood in. The idea was supposed to be (though Barry and Ben did not require)that they would hold those profits to rebuild their balances sheets. As it turns out, they handed out about half in bonuses and paid out nice dividends. The rest went to balance sheets.

    Ever get the feeling you've been cheated?

  • mark||

    one of the reasons banks are holding so much cash is that the Fed is paying them interest on it. thinking of paying interest on it starting in October 2011.

  • ||

    Bernanke better hope that when the time finally comes for his much-needed firing, it doesn't involve a squad.

  • ed||

    Smells like teen nascent.

  • ||

    For some years now I have been arguing that CPI, PPI and other measures of inflation are no longer adequate to the job. The constant changes to the basket of goods does not allow for a good year over year comparison nor do they capture the true increases in cost to both businesses and consumer.

    The nature of our economy has changed and the policy makers are not up to the task. These are the pitfalls for all central planners and has been their downfall throughout history.

  • TP||

    I found a good article at mises just a little while ago (believe it or not) from 2003. It enumerates several myths of deflation. But, I'm sure, after going through the comments, it's just preaching to the choir.

    http://mises.org/daily/1254

  • ||

    There is a nascent recovery under way. As I will describe, I expect it to continue.

    A nascent recovery is one that is just beginning. How can something continue to just begin?

  • ||

    Real GDP began to grow again in the third quarter of 2009. In fact, that growth rate accelerated to a seasonally adjusted annualized rate of 5.7 percent in the fourth quarter.

    These assertions assume that inflation is not being under-reported.

    Frankly, I have become an agnostic on the whether we've been/will be in an inflationary or deflationary period for the short term. The money supply is sky high, but trillions were previously pumped into the economy/destroyed in the CDS/CMO debacle, so WTF knows.

    Now, I do believe that we will see inflation shortly. All that cash will start to circulate at some point . . .

  • Invisible Finger||

    Speaking of which, does anybody remember certificates of deposit? I mean, they still exist, but does anybody remember when they were the only decent place to put your money?

    For all intents and purposes, a CD is like buying treasuries. When you open a CD, the bank will usually buy treasuries. (Individual are limited in how much direct treasuries they can purchase.)

  • alan||

    For all the intense porpoises, oh, the huge manatee!

  • guy in the back row||

    I remember in the 70s when the rates were 15% for a three month CD. My aunt and uncle made a ton of money that way.

  • ||

    Depends. Inflation was at times >15%, so while they got cash, it wasn't worth what it looked and counted like.

  • ||

    "Evidence of lower prices on women's apparel, passenger cars and computers indicates that weak consumer demand is still holding back price growth in other parts of the economy."

    Price indices for apparel and computers have been falling forever in the government's CPI. They're hardly indicators of weak growth or inflation being contained.

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