Intervention without inflation September 19, 2008 Wow, where do I begin? This week has seen so much turmoil, fear and intervention that I was tempted not to write a letter at all. I figured you would have had your fill of economic entertainment for the week.
Fear reached the point where, on Wednesday, the yield on US Treasury Bills briefly fell below zero. In the midst of the fear I recognized that many investors were desperate to get their hands on US Government bonds, so I did my part and sold them some, even though I did not have any. Thus far we are all much happier. They got their bonds and I made a profit – on paper at least – since bond prices are much lower today than they were on Tuesday.
On Wednesday the gold price increased by more than $100 an ounce. Was gold’s reanimation a sign that inflation has been rekindled or merely a barometer of fear? There was undoubtedly much fear, but have these bailouts created inflation?
The Fed has already made hundreds of billions of dollars available to the financial sector, but most of its programs have thus far not added to the money supply. That means the Fed’s programs have been neutral, creating neither inflation nor deflation.
When a bank borrows money from the Fed the loan increases bank liabilities, but it does not increase bank deposit liabilities, and it is bank deposit liabilities that are part of the money supply. Only if the bank spends the money it borrowed will it show up in the money supply, but if the bank uses the money to shore up its reserves on deposit at the Fed, which is where most of the money has ended up, there would have been no increase in the money supply.
The second type of assistance the Fed has made available is asset swaps, whereby the Fed swaps Treasuries for lower quality assets such as collateralized debt obligations. Asset swaps do not add money to the money supply either.
Fed loans to non-banking institutions can be inflationary, since the money will immediately show up in a bank deposit account somewhere. However, the Fed can offset such loans by selling US Treasuries from its portfolio and it is my understanding that the Fed has, by and large, done exactly that, which is why the inflation rate has not increased nearly as rapidly as many people would like to believe.
The Fed can create any amount of inflation that it wants to create, but it has been very careful throughout this crisis not to create inflation. The historically high inflation rates that we have perceived, and that peaked in March, may well have been created through the expansion of corporate and consumer debt and not directly by the Fed. Given its actions of late I am leaning more and more towards that opinion.
Many people have commented that the Fed’s balance sheet has deteriorated because of all the mortgage and other collateralized debt that it has taken on, and it has even been said that the Fed will run out of Treasuries to swap and lend. Of course, this is nonsense. The Fed can create money at will and can literally buy an unlimited amount of Treasuries. The problem is that when the Fed creates money and buys Treasuries it directly increases the money supply with the newly created money and the Fed, perhaps better than anyone, understands that when it inflates the money supply it devalues the dollar at the same time.
That is why, instead of creating new money to buy Treasuries, the Fed this week asked the Treasury Department to auction an additional $100 billion worth of T-Bills and deposit the proceeds in its account at the Fed. Now, consider what this means:
Instead of the Fed creating inflation by using new money to buy Treasuries, the Treasury Department will sell additional T-Bills into the market. The money it receives from these auctions will be deposited at the Fed, thus extracted from the money supply -- clearly deflationary. If the Fed then uses this money that the Treasury has deposited to make loans to non-banking institutions, or to buy Treasuries in the market to replenish its portfolio, the money would re-enter the money supply and the net result would have been absolutely zero additional inflation.
The Fed has gone to great lengths to reduce the inflationary impact of all of its bailouts thus far, in contrast to people’s expectations of what Bernanke would do since he publicly stated he would flood the market with new money to avoid deflation. We can only assume that he is not yet concerned enough about deflation. That would corroborate the observation that we are currently still in a very high inflationary environment. The Fed’s efforts to avoid any additional inflation also confirms this observation.
Knowing that Bernanke is willing to create inflation and seeing him refrain from doing so can also mean that he is hoping the banking crisis is going to fix itself without him having to resort to inflation. Personally, I don’t think it’s going to work, and I think he will ultimately have no other way out. Having said that, I don’t think he is going to create anywhere near the kind of inflation some people expect, and we are certainly not at any immediate risk of hyper-inflation. That is about as likely as hyper-deflation at this time.
Since the facts show that the Fed has not been creating massive amounts of new inflation, and this week’s Treasury program to assist the Fed is clearly not inflationary, it is unlikely that the gold price reacted to new threats of inflation. It is, therefore, more likely that this week’s jump in the gold price was merely a reflection of the same fear that drove T-Bill rates to zero.
I am going to wait and see if the gold price will pull back to under $760 an ounce again and if it falls sufficiently below that value I will start buying gold again. In the meantime, being short bonds is a risky position but eventually bonds are going to top out. With no end in sight for the banking crisis I still believe inflation is a bigger risk than deflation, and with already deeply negative interest rates bonds are currently, fundamentally, grossly over-valued. I’ll stick to that trade for a while.
I discussed these ideas on BNN on Friday, and you can watch the segment on BNN’s website here (
link).
Paul van Eeden
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