Stubbornly attached to the (now technically defunct) fear of a double dip, fretting deflation and inflation has recently been all the rage. These fears have been so prevalent, we've written about them a few times here at MarketMinder (click here for previous columns). We've previously debunked comparisons between our current state of affairs and historical episodes of deflation/hyperinflation. However, we can go one step further and drill down to the root cause of these fears. Inflation/deflation fears are actually subsets of a larger worry: What if central banks make a major policy mistake? Possible, but it hasn't happened yet, and there's no reason to expect one in the near future. The Federal Reserve and its peers have some obstacles in front of them, but they appear well aware of the obstacles and none are insurmountable.
First, let's be clear. The global monetary support by central banks has certainly been appropriate up to this point. Following the bankruptcy of Lehman Brothers, credit froze and central banks applied a solution straight out of a college freshman's economic textbook. Based on the following economic equation, they increased money supplies.
M*V = P*Q = Nominal GDP
M = Money Supply, V = Velocity of Money, P = Price, and Q = Output.
When the velocity of money (how often it changed hands) fell significantly, central banks turned on the printing presses and swapped illiquid assets on bank balance sheets for cash. In the US from August 2008 to November 2009, cash in circulation and bank reserves (often known as M0) increased a whopping 139% and remain near highs to this day. However, over the same period, money supplies in the broader economy (measured by M2: basically cash in circulation + checking accounts + savings accounts) only increased 9%.
The reason for the difference? Boosting bank reserves only boosts the broad money supply if banks lend those reserves—lending is a natural money multiplier. For example, in the US we have a 10% reserve requirement, so a bank with $100 must hold $10 and can lend out $90. That $90 then gets deposited at another bank, which holds 10% and lends out the rest. This can happen over and over until each initial dollar deposited is multiplied a maximum of 10 times (i.e., $1 becomes $10 dollars). The strength of this effect hinges on whether banks lend the legal max—if banks are in a conservative mood, as has been the case recently, they may hold greater reserves, thus reducing the multiplier.
During the crisis, with minimal bank lending, cash was not being multiplied at its normal rate. The Fed's huge liquidity injection was thus appropriate and remains so, given still-recovering capital markets. However, as the economy heals further and bank lending and velocity return to normal levels there is the potential for a monetary error. The Federal Reserve will need to pull much of that cash back out of the system to prevent it from flooding the overall economy with money. If they do this too slowly, they may contribute to uncomfortably high inflation. And if they move too quickly, the money supply could drop, causing deflation and potentially another recession. The one option no one seems to want to discuss is what happens if neither mistake is made. Real economic growth perhaps…?
So are we approaching the time when the Fed needs to consider reversing stimulus? Since freezing in late 2008, credit has generally been thawing. In some regions it has improved faster than others. (Take a bow Emerging Markets—where the banking systems remained largely healthy through the downturn and recovered quickly once global risk aversion subsided.) But even the US has seen improvements. Mark-to-market accounting's negative effects are largely gone. Stress tests are done (which incentivized hoarding of cash). Banks have been recapitalized. Housing prices have mostly stabilized. Yield curves are steep (the difference between short and long rates, which determine bank profit margins and are a primary incentive to lend). And US financial legislation has been completed. Going into Q3, all this led to the first net loosening of US bank standards for consumer loans, prime mortgages, and small bank commercial loans in over two years (based on the Federal Reserve's Senior Loan Officer Survey).
However, credit conditions aren't so healthy the Fed has missed its window—as low levels of inflation should testify to. Quite a bit of uncertainty remains. Washington is discussing levying fees on lenders to support Fannie Mae and Freddie Mac. Basel III capital ratios are mostly hammered out, but many details have yet to be finalized, including what counts as capital. And while US financial legislation has been passed, it largely kicked the can to regulators to determine final rules and implement as yet undefined financial regulations. In particular, it's still unknown just how the well-funded Consumer Financial Protection Bureau will work. The bright side is it will be regulators who theoretically understand the industry setting the rules, instead of Congress. But as a bank officer it would be pretty hard to completely open the floodgates with all of that uncertainty.
This uncertainty should continue to wane over time, helping credit continue to flow and the economy to continue to recover. As credit markets continue to heal, the Fed will need to make some big decisions. But investors will have time to judge the Fed then—whatever the central bank does, the effect of monetary policy is not immediate. Looking for a nasty bout of deflation or hyper-inflation is a low-probability bet on a future monetary policy mistake. Don't hold your breath.