A question was recently posed by a client: After years of intervention from the Federal Reserve and increasing levels of debt, why is there no inflation?
Conventional wisdom suggests that inflation is an inevitable byproduct of so called “quantitative easing.” Quantitative easing is when a central bank purchases assets (usually debt instruments) from banks and credits money on their balance sheet. This money can then be used by the banks for lending. In theory, quantitative easing is a way to inject liquidity into the markets beyond traditional monetary means of lowering interest rates. Once interest rates have been lowered to zero, quantitative easing is a secondary tool that can be used to continue to stimulate the economy. The U.S. has been “easing” almost unabated since 2008 when interest rates were lowered to zero. Rates have remained at or near zero since, despite an attempt to return to normalcy, where rates breached 2% for a short time only to have to be cut back to near zero again.
The initial “Quantitative Easing,” or QE1 ended with the Fed’s balance sheet ballooning from ≈$800 billion to $2.1 trillion by June of 2010. QE2 and QE3 resulted in balance sheet assets of $4.5 trillion by October 2014. Post- pandemic, the Fed’s balance sheet now has a whopping $7.4 trillion in assets. In addition, the composition of the Fed’s balance sheet expanded from just U.S. treasuries to include mortgage backed securities following the 2008 financial crisis. The Fed now accumulates corporate bonds, municipal bonds and loans to businesses via its Mainstreet Lending Program in this latest round of quantitative easing.
With all of the liquidity injected into the banking system and with an accompanying increase in access to borrowing at very low cost, why are the prices of wages and goods and services not rising?
In the economic cycle following the great financial crisis of 2008, the CPI (Consumer Price Index) increased on average only 1.7% annually. During this time, the Fed’s target was 2.0%. Prior to this, inflation in the 2 – 3% range was generally considered to be acceptable and a good level for a sustainable economy. Where is the inflation now?
The chart above shows the amount of assets on the Feds balance sheet, along with the velocity of M2 which is put simply by the Fed:
The velocity of money is the frequency at which one unit of currency is used to purchase domestically- produced goods and services within a given time period. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy. Source: Federal Reserve Bank of St. Louis.
Inflation has been called “too much money chasing too few goods,” and there is quite a lot of money on the sidelines. Personal savings rates are at historically high levels and the drop in industrial production has outpaced the reduction in GDP related to the pandemic. Perhaps money is simply sitting on bank balance sheets, corporate balance sheets and in consumer bank accounts waiting for economic conditions to improve to the extent that there is comfort in expanding capacity and employment, expanding lending, and expanding consumption. Or have years of low rates resulted in companies and consumers who are unwilling to part with savings or reserves on fears that low rates, low prices and low opportunity will persist or go lower? One only has to look at Japan.
The intent of quantitative easing was to increase the monetary base, which would spur economic activity and the velocity of money. But because the increased velocity part hasn’t happened yet, we are left with uncertainty as to the long-term impact of the Fed’s actions on inflation. We have only the experience of these policies in other countries as a guide. Substantial distinctions can be made between the U.S. economy and these economies, but if comparisons are made, we will not see inflation in the U.S. any time soon. That said, the basis for inflationary conditions (large amounts of potentially “excess” money, supply dislocations, input imbalances, and pent-up demand) are in place and will continue to warrant our significant attention.
Sources: FactSet, Federal Reserve Bank of St. Louis, Federal Reserve Bank of New York via GLOBALT Investments. Data and Analytics provided by FactSet. Author: Kimberly Woody, Senior Portfolio Manager – GLOBALT Investments.
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