Wednesday, October 12, 2016

Why Isn't The Fed Getting Inflation?

After listening to Janet Yellen during the last FOMC meeting I began really wondering why the Federal Reserve wasn't reaching it's 2% inflation target. At just about every FOMC meeting, and speech by a Fed President this year, it has been mentioned our economy is not reaching their 2% goal. I started to wonder what CPI and other data sets were looking like from a longer term historical perspective. So I began some research.

Before we go any further I want to remind people that inflation is not caused by an increase in money supply alone. That will be addressed in the article and you'll see the results for yourself. Also inflation has multiple drivers and faces.  I'll be addressing parts of it here.

Here is what I found.

CPI's Long Term Downtrend

I took a deeper look at the historical rate of inflation. Starting in the 80's a new inflation trend developed. It appears the Fed is fighting a much longer dated trend than most people realize.The actual rate of inflation is the blue line. You can see it is occasionally erratic. You can also see the current rate of inflation is below the Fed's target rate(green line).
Source: MAD Consulting LLC © 
Notice the long term declining trend channel since the late 80's. This downtrend actually goes back to 1979 when inflation hit a high of 13.2% and has been falling ever since. In order to boost inflation following the financial crisis the Fed embarked on a series of controversial activities starting in 2008.

Can QE Light the Inflation Fire?

Recall the Fed's QE programs. While sounding complex it's simply the Federal Reserve buying mortgage and government debt from banks.

The Fed has spent $4.3 trillion on  Mortgage Backed Securities(MBS),  and US Treasuries through it's Permanent and Temporary Open Market Operations since 2008. This money was spent buying assets directly from banks. You can see each program show up in the inflation chart above with a corresponding spike to inflation such as in 2009 and 2010-2011. However despite these massive stimulus efforts the economy is still unable to maintain the 2% target rate.

Of that $4.3 trillion spent the Fed currently holds $1.7 billion Mortgage Backed Securities, and $2.4 trillion in Treasuries(US Gov Debt). Basically that amounts to 95% of the Fed's balance sheet. I'll have an article covering details about the Fed's Mortgage Debt and Government Debt outstanding published in a few days.

Where Did The Money Go?

If the Fed literally created and injected $4.3 trillion into the banking system that money has to go somewhere right?

Let's take a look at something called Excess Reserves of Depository Institutions. You might be saying "Hold on here MAD Consultant this is getting complex. I just want to watch videos of pigs in blankets". Well it's actually quite simple..

This number represents the amount of funds banks have on deposit at the Federal Reserve. Remember the Federal Reserve is the bank for banks. After the Fed purchased these assets from banks, banks turned around and deposited the funds at...(c'mon take an easy guess)

... the Federal Reserve (I knew you'd guess that one!) where it currently earns a nice clean risk free 0.50% since December 2015. Previously it was 0.25%.  Of course you can see Excess Reserves have skyrocketed since the financial crisis when the Fed embarked on it's QE programs. Excess reserves currently stand at $2.2 trillion and hit a high of $2.6 trillion. Basically banks have deposited at least 50% or more of the money received at the Federal Reserve

Not a bad deal if you are a banker.  Instead of lending the money out you can simply turn around and park the money right back at the Federal Reserve with near zero risk and still make money.

Why would banks do that?

That's an easily answered question. If you don't see an opportunity to lend the money out at a profit in the private sector you simply keep it on deposit at the Federal Reserve. Remember all that talk about how hard it was to get a bank loan the last few years? This is a big reason why. If banks did not want to, or did not see the opportunity to make money from loans, they could still earn profits from the Fed. That's just basic human instinct when you are trying to reduce risk and run your business.

Note this strategy is opposite of what the ECB, and other central banks are currently implementing. They are charging banks a negative interest rate on their excess reserves. In essence if banks do not lend the money out the ECB will take a piece of it instead.

But that isn't the whole picture why FOMC policies aren't producing inflation. Part of inflation has to do with a little something called money supply and velocity.

What is Money Supply & Velocity? 

There is a measurement of money supply called M1. It basically counts all cash, money stored in checking accounts, travelers checks, and other checkable deposits. This represents easily accessed funds.

M2 is another measurement that includes M1 and also: savings deposits(ie MMDA's), time deposits(certificates of deposit), and money market mutual funds. Generally M2 funds are slightly less easily accessed. They usually involve some type of account restriction on your access to the funds.

These two measurements basically tell us the amounts of cash held by individuals and business to operate on a daily to weekly basis. Since we can measure the quantity of money we can also measure how often it's exchanged, or velocity.

Velocity is exactly what you might think it is with money. The quicker money is exchanged from one individual to the next the higher the velocity will be. On the other hand if people don't transact money a lot the velocity will slow. So a higher velocity generally signals a stronger economy as exchange between individuals and business is brisk. Lower velocity is exactly the opposite as it means individuals and business are deleveraging, or holding onto their money instead of exchanging it for goods and services with each other. Let's look at M1.

Notice the inverse direction of M1 money supply stock and it's velocity since 2008

Since January 2008 to August 2016 M1 has increased by $1.9 trillionThe money supply more than doubled in 8 years yet the rate at which money exchange's hands has fallen in half during the same time period. In other words people and business' are holding onto their money instead of buying goods and services. 

M2 as you might expect shows the exact same trend so I did not include a chart depicting velocity, but I have included it in another chart below with other data. Let's take a look at one of the broadest views of money supply with MZM(M3 is no longer calculated).

Note the long term declining trend in MZM velocity since the 1980's. This happens to correspond to the falling inflation rates I noted in the first chart above. MZM is very broad and closely watched by the Federal Reserve. 

Now I've included CPI with the monetary base so you can see QE's impact on inflation was not nearly as significant as expected. Notice the CPI Index continued for the most part on it's steady upward trend. Don't confuse this with the declining trend I pointed out above since this is an indexed number I'm presenting in this chart. As you can see the massive money supply increase barely fanned the inflation embers. You would think according to classic inflation theory that a larger monetary base would create a corresponding surge in the rate of inflation, and overall price levels. It would have better chances if aggregate demand and money velocity were also strong.  But there is a lack of that right now.


Last chart I promise! Here is M2 versus Excess Reserves and the Monetary Base.


So there we have it. On a Macro level we can see some of the main reasons why the Fed isn't reaching it's inflation target. Now this isn't every reason, or all the data. But it's a good start. Below is probably the simplest way I can explain it.

People and business are not spending money because they are uncertain about the future. I hear about it with people I talk with. In financial news it's often discussed as a lack of business investment. I've mentioned business investment in economic releases on the blog before. Companies are uncertain about the future so they invest less while they send money either to the bank account, or to shareholders via buybacks and dividends. Individuals on the receiving end of those dividends and buybacks aren't spending the money either. They are saving it too.  Banks are even in on the game and they aren't spending...A'hem I mean lending... money either.

This also explain's part of why GDP growth has been slow.  So go ahead re-read this and take a look at all charts again. I know, there are plenty of them. Feel free to leave a comment with your own thoughts, and if you have any data showing similar or different correlations please share so we can all become better informed.

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