Where's The Beef? Inflationary Comments
First, some humor:
For those of you who missed it, we had very low inflation readings last week. Again. Where the heck is the inflation? The Federal Reserve has been shoveling reserve dollars into the financial system for 13 years and measured inflation has been falling the entire time.
Why should we care about inflation?
1. It affects the stability of prices, which affects our standard of living
2. It is targeted by Fed policy in ways that dramatically affect the markets
3. It is a sign of government mismanagement if too high or too low
4. 1970s style inflation will be really bad for stocks and bonds
The 2 Ways The Fed Affects Inflation
There are two methods the Fed uses to influence the real economy and inflation: interest rate management and quantitative easing.
The primary way they try to influence inflation is by suppressing or increasing short term interest rates. In particular, they focus on interest rates in the overnight borrowing market such as the Federal Funds Rate, London Interbank Overnight Rate (LIBOR) and Secured Overnight Financing Rate (SOFR is the new LIBOR). Using policy language and other tools, they also try to influence where long term US Treasury bond yields and mortgage bond yields get set.
For assets purchased with debt like real estate, stocks and bonds, suppressing interest rates below inflation makes the asset more valuable or expensive because real borrowing costs fall. Buyers are able to borrow more and pay more, so guess what? They do! We see this effect vividly in our real estate, stock and bond markets today. The effect on the real economy in wages and goods is much more muted.
The secondary way the Fed tries to influence inflation is by creating reserves for the banking industry. This is known today as “quantitative easing” or QE. Contrary to what Fed Chairman Powell has stated, the Fed does not “print” money. The Treasury department is legally and practically responsible for that. To prove that to yourself, pull out a dollar and look at who signs it. Your Federal Reserve Note is not legal tender unless the Secretary of the Treasury signs it. In theory, giving excess reserves to the banks should be “like” giving them cash. Hopefully, the banks will trade or lend the cash and that will increase the money supply in the economy. Unfortunately for the Fed, that is not what we see in practice.
Theory and Practice
Many of you are familiar with Yogi Berra and his famous sayings. Here is one of my favorites: “In theory, there is no difference between theory and practice. In practice, there is.” While Yogi may have been talking about baseball practice, it is also a good critique of the Fed’s quantitative easing policies. In theory, quantitative easing (the creation of excess cash reserves for the banks) should inflate the money supply and create inflation. In practice, we observe that the banks do not consider excess reserves as cash. They do not lend it or trade with it. It sits inert on their balance sheets for a variety of reasons.
Here is a chart comparing the Fed’s balance sheet with reserve levels in the banking system (notice that prior to the financial crisis, bank reserves were minimal):
In theory, if banks used this cash for lending, the Fed could very easily control lending behavior and inflation in the real economy. However, in practice, the banks are constrained by regulations, economics, and opportunity.
New regulations from the 2010 Dodd-Frank Financial Reform Bill changed how banks must treat certain loans on their balance sheets. Without getting technical, the law encouraged them to lend to governments, but not businesses.
From an economic perspective, if the economy is in recession, the banks are naturally reluctant to lend. Their borrowers might default causing losses. The Fed can’t control this behavioral pattern.
From an opportunity perspective, the banks today have ways to borrow money that are not easily captured by conventional accounting and regulations. What this means is that the excess reserves created by the Fed are not the cheapest source of cash for the banks to use in the normal course of business. What the chart above is telling us
is that the banks don’t care about reserves or quantitative easing from a banking perspective.
Finally, quantitative easing works wonderfully as a signaling mechanism to the markets. Stock, bond, and currency traders follow every word from the Fed about future QE policies and trade accordingly. This is also a behavioral pattern.
Another reason inflation is low
Let’s assume for a moment that reserves created by the Fed are treated as “cash” by the banks. Naturally, that type of monetary expansion on its own would be considered inflationary. Banks are levered entities that historically would lend multiples of new cash to the market place. If the bank leverage was 5:1 and the bank received $100 million dollars of cash, theoretically they could lend $500 million dollars if they wanted to without breaking their reserve requirement rules.
But what if there was another branch of government absorbing all that extra Fed cash in such a way that it did not flow through the banks to the real economy. This is what we see in practice as the Federal Government has run huge deficits for years. Many people automatically tune out the news stories about record deficits and national debt. There is a strong narrative that the Federal Reserve bought more than enough Treasury bills, bonds and
notes to fund the government in 2020. In reality, while the Fed bought $3.2 Trillion in assets in 2020, the Treasury issued $4.5 Trillion in securities to the marketplace.
Here is a chart that shows Fed QE, Treasury borrowing and the difference between the two in 2020. The US Treasury borrowed $1.3 trillion MORE than the Fed created in reserves during 2020.
What will it take to spike inflation like the 1970s?
Interest rates in major markets like Japan, Europe and the U.S. have been falling for decades. In all cases, interest rates have been pushed down by central banks as easy ways to stimulate growth, yet the baseline of GDP growth continues to fall in every region. Why? Markets are assuming governments will have to pay back the debt with higher taxes or lower spending which are deflationary policies. The risk for governments is that the markets
suddenly fear default as we saw in Argentina, Ireland, Greece, Portugal, Spain and Italy in 2011. This scenario would be very difficult for the U.S. because our joint budget and trade deficit (we borrow from foreigners to fund our economy).
A sustained rise in inflation will require several key factors:
1) A repeal of the Dodd-Frank Financial Reform bill and a general easing of bank regulations.
2) Higher expectations of inflation by consumers.
3) A robust and growing economy with minimal unemployment.
So far, the only factor present is a mild rise in inflation expectations.
If you would like to talk about the implications of this research on your situation, please give us a call.
Robert Lloyds, CFA®
Chief Investment Officer
Lloyds Intrepid Wealth Management
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