“You loan me ten bucks. I photocopy the bill four times, give you back one of the copies, and announce that we’re square. That’s monetizing the debt.” From Lionel Shriver’s The Mandibles
In the private sector, it would be called a Ponzi scheme. When the Federal Reserve Board does it, it’s called “monetizing the debt.”
The Balance explained that, “The Federal Reserve monetizes debt any time it buys U.S. Treasuries. When the Federal Reserve buys these Treasuries, it doesn’t have to print money to buy them. It issues credit and puts the Treasuries on its balance sheet. Everyone treats the credit just like money, even though the Fed doesn’t print cold hard cash.”
The process lowers interest rates, because the bonds taken out of circulation reduce supply, driving demand higher. But if reducing the supply of bonds drives prices higher and interest rates lower, shouldn’t more dollars drive the value of the dollar lower and the price of goods higher?
Logically, if you were to double the supply of money tomorrow, a dollar should be worth half of what it is worth today. Prices would double, so the rate of inflation would be 100%.
And yet even with boatloads of new money, the inflation rate has barely budged. The M1 money supply, which includes cash, checking accounts and other liquid monetary assets, is about 245% higher than it was eight years ago, when the Federal Reserve Board began its easy money policy. Meanwhile, the Fed has been reluctant to increase interest rates in part because it has not been able to reach its targeted inflation rate of 2%.
With trillions of dollars pumped into the system, hyperinflation should be a concern. Yet the Fed’s Minneapolis bank estimates that the rate of inflation will be only 1.1% in 2016, after a rate of 0.1% in 2015, 1.6% in 2014 and 1.5% in 2013.
With the world’s most brilliant economists on board (except, perhaps, for those running the European Central Bank), shouldn’t the Fed’s Open Market Committee be asking, “How can this be?”
Why Inflation Is So Low
We don’t have a definitive answer to that question, but we’ve mulled over a few possibilities.
It’s All Relative. Just about every other country in the world with a significant economy has followed the U.S. lead and instituted one form or another of quantitative easing.
It’s a central bank form of protectionism. When one central bank prints more money, weakening its currency and making exports cheaper, other countries follow suit, causing a currency war.
Today, the Fed is no longer buying bonds, even though it’s kept interest rates at about zero, while other central banks have continued some form of quantitative easing. With most of the world following easy money policies, the dollar has been propped up (although it’s weakened somewhat recently), keeping inflation in check.
The Official Inflation Rate is Bogus. A Zerohedge post from Paul Craig Roberts says, “In times past we could get a reasonable idea of how the economy was doing, because the measure of inflation was reasonable. That is no longer the case. Various ‘reforms’ have taken inflation out of the measures of inflation. For example, if the price of an item in the inflation index goes up, the item is taken out and a cheaper item put in its place. Alternatively, the price rise is called a ‘quality improvement’ and not counted as a price rise.”
While the price of oil has dropped, sending the Fed into a panic about the possibility of deflation, the price of healthcare, food and other essentials has risen. With federal officials gaming the rules, as they have with the unemployment rate, no one really knows what the real rate of inflation is.
“Anyone who purchases food, clothing, visits a hardware store, and pays repair bills and utility bills knows that there is a lot of inflation,” Roberts wrote. “Consider prescription drugs. AARP reports that the annual cost of prescription drugs used by retirees has risen from $5,571 in 2006 to $11,341 in 2013, but their incomes have not kept up. Indeed, the main reason for ‘reforming’ the measurement of inflation was to eliminate COLA adjustments to Social Security benefits.”
This Has Never Been Done Before. The Great Recession has no historical precedent and neither does the Federal Reserve Board’s attempts to rescue the economy by purchasing $4 trillion worth of bonds.
It’s clear that the economy remains fragile at best, although you’d never know it from today’s stock prices. But what’s not clear is what the long-term impact of seven years of zero interest rate policy (ZIRP) will be.
Inflation Lags. Buying bonds today doesn’t cause an increase in inflation today. It takes time for inflation to make its way through the economy. We may be on the cusp of a period of high inflation without even realizing it.
That period may have already begun, but you wouldn’t know it by tracking the official rate of inflation. So for now, we’ll just continue ZIRP, get through the presidential election and then see what happens.