37% of all dollars currently existing were created last year, as measured by the M2 money supply. If you are a bit shocked and a tad worried, congratulations, your emotions are properly calibrated. Today, we have two mysteries to solve. First, since low rates and central bank balance sheet expansions have been going on for a while, where is the inflation? Second, will current events, like this 37% surge in dollars, finally push us into the long awaited price level rise?
Public and private money creation:
Public money creation gets all of the press, fooling people into thinking this is where all our money comes from. However, the majority of dollars in existence were created in the private sphere, through fractional reserve lending. In the aftermath of the Great Recession, it was highly publicized that the Fed began creating additional dollars through Quantitative Easing (QE). What we forget is that during this time, bankruptcies of private loans destroyed dollars, causing debt deflation. Everyone heard about the unprecedented inflationary vector, but no one really commented on the collapse of private lending and dollar destroying deflation events centering around mortgages.
At least at first, the two vectors canceled each other out. It is true that the magnitude of the QE vector increased and continued past what would have been necessary to counter those deflationary pressures. What happened next was a prolonged QE program and low to negative interest rates. In part, this was to keep the money supply at the inflation target because private money creation was at a crawl. Slowing down this already leisurely private money creation was Dodd-Frank legislation. As for money created over and above that quantity? This is where bank reserves enter the story.
Banks will commonly hold 10-20% reserves at any given moment. This was no longer true after quantitative easing. These banks were flooded with cash, restricted with tighter lending requirements, and in the midst of a sluggish economy demand was low. The Fed, fearing inflation and bank collapse, offered interest on the excess reserves held at the Fed. In short, they created dollars, gave them to the banks, and the banks gave them back to receive interest payments. Naturally, this prevented those excess dollars from producing inflation.
Imagine all of those reserve dollars are a lake and what is preventing them from rushing into the economy is a dam. Last time I checked, the dam is 0.75% interest high. Much of our would-be inflation is behind that dam. If the banks can’t receive a risk-free 0.75% interest rate on those funds in the market, then the dam will hold. If, however, inflation picks up or demand increases such that the prevailing risk-free rate is much higher, the dam will be insufficient, and the money will come flooding in to the market. It is important to remember that the Fed has enormous power and can raise the height of the dam with the stroke of a pen whenever it wishes.
So there is part of the answer: inflation is dammed upstream in the excess reserve lake. In the future we could see inflation, but it could also be halted, using tools the Fed has already deployed. There are questions about whether it will deploy these tools. One very possible pressure is the Federal government, which would love to see a modest amount of inflation in order to lower the real interest rate of its bonds.
Some have proposed that the surging stock market is soaking up inflation like a sponge. This is a problematic theory, in part because there is always a counter-party in each stock exchange. The money isn’t pooling when a stock rises. It is being transferred from a new buyer to an older one. It is true this money is often used to drive up the value of another stock, and with sufficient trading volume it can keep some inflation out of the broader economy. An analogy would be juggling. High trading volume is like throwing more balls in the air. The balls that are suspended in the air and not being held could represent the inflation that is soaked up by the trading activity in a soaring stock market.
Buybacks act differently. Starting at the beginning of the latest market crash, S&P 500 companies poured 130% of their profits into buybacks. This mirrors the sponge analogy much better. My back-of-the-envelope calculations show that the effect of this level of buybacks account for a missing $600 billion per year of inflation, or roughly 4%.
With buyback restrictions coming as part of COVID-19 relief funds, this could mean these dollars will enter the rest of the economy. That said, only a few companies are under such restrictions, and this trend could continue for a while. The more companies do this, the fewer shares are on the market, and the greater the volatility of their value. This actually explains a lot of the speed of the last market crash. This trend can’t continue forever, because it would end in all of the companies owning all of their shares and becoming private.
Bottom line on this one? Unlike the first cause, this one will eventually end. We can count on about 4% inflation, if it ended completely. It is one part of the riddle of why we haven't seen inflation. In a normal economy, the buybacks that are financed with debt would represent new funds entering the economy; however, as we saw in the bank reserve section, many of those dollars could be held out of the market. This means we are left with deflationary pressure.
Cheap debt increasing capital expenditures:
The third reason for lower inflation is the rapid increase in capital expenditure. If Burger King is considering building another restaurant and the capital cost is 5%, they may require a return of at least 7% to justify it. But, if through lower rates and QE, the prevailing rate is 1%, then they could comfortably build a restaurant even if it gives a relatively unproductive 3% return.
McDonald’s makes the same calculation and the result is an expansion in the supply of burgers along with increased competition between geographically closer stores. This naturally leads to lower prices.
This third answer to our two riddles is less commonly addressed, but nevertheless very important. Moving into the future, this trend will slow. The most productive assets will be funded first with lower and lower incentives for further expansion. That said, if inflation rises, the real rate of interest falls- and these types of establishments can adjust to inflation rapidly. They may choose to expand some more. The net effect of these types of establishments is unclear moving into the future, at least according to my crystal ball.
Wage floors, like the proposed $15 minimum wage, may create inflationary pressures. So, too, would a tightening labor market, caused in part by the aforementioned expansion of supply. Velocity of money is a factor to consider, but the bottom line is this. In the words of Milton Friedman, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” As we have seen earlier, a demand shift for money would draw in the supply currently held in excess reserves. Velocity of money would be the proximate cause of inflation.
Some trendy economists act as if velocity-of-money measures are equal to quantity-of-money measures in predicting inflation. This ignores the fact that velocity is regulated by real speed-breaks as it moves through the economy, in the form of timed wage payments, termed debt payment, or CD’s, to name a few. Analyzing money price levels in traditional terms of supply and demand remains the most accurate and rational way of predicting inflation.
To answer our first question in this context (where was the lost inflation since the Great Recession?): some of the missing inflation is due to the comparatively weak demand in the economy writ large, and the labor market in particular. While it is true that unemployment has been low, during this period total labor participation has also been historically low. This means there was unmeasured slack in the labor market preventing the predicted wage inflation, as unemployment fell during the long and slow post-2008 recovery.
Looking to the future, it is likely that wages will begin to finally rise. This is partly because household balance sheets have ballooned from recent stimulus and unemployment payments. This could cause a consumer demand surge as fear abates and spending increases. This additional demand chasing the current supply of goods will create inflation which could pull funds into the real economy from reserves.
Oil is not included in the consumer price index. However, a drop in oil prices does in fact reduce almost all prices, due to its pervasive usage throughout worldwide economies. Oil didn’t just fall from 2007 pre-crash levels, but it actually went negative at some points. My back-of-the-envelope estimates estimate a deflationary pressure of about $300 billion per year. This amounts to around 2% of inflation avoided through lower oil prices. Although I focused on oil, a similar story could be told about other commodities as well.
The future of oil prices are unclear. If I were to venture a guess, I would imagine that prices will remain low. This is based on Saudi Arabia's willingness to aggressively fight a price war, as demonstrated by the cratering prices from a few months ago. Furthermore, US production costs have been steadily dropping. Some estimate these costs have dropped to a break-even level around $37 dollar a barrel. The demand side is unclear, with large emerging economies like India being the ones to watch. Of course, taxes and regulations play a huge role in this market as well, which can change suddenly and without notice.
A host of factors have been stifling inflation thus far. Not all of them can continue indefinitely. There are other curve balls for which we have not accounted. For instance, global dollar demand from trade, or hunger for comparatively safe US assets can affect inflation. Overall, it seems that the most likely scenario is rising inflation, coming soon. The Fed will allow this trend to continue to levels not seen in a few decades, in part to help the government pay their enormous debt burden. Interest on reserves have become the primary tool of the Fed. This number is more important than the inter-bank trading rate, because all banks are flush with reserves, they will rarely require inter-bank lending.