Deflation is Today’s Threat, Not Inflation

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Deflation is Today’s Threat, Not Inflation
by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
April 6, 2009

Throughout the current financial crisis, the Federal Reserve has distinguished itself with its intrepid balance sheet expansion. These extreme policies, along with those of the Treasury Department, have unleashed a growing fear of inflation. The thinking goes that with all the money that’s being pumped into the system, when the economy revives all the liquidity will morph into inflationary demand. On top of this, there’s competitive currency depreciation and rising protectionist sentiment around the globe. If anti-trade policies gain traction, it will disrupt the disinflationary benefits of globalization. Put it all together, and many now fear the inflation bogey man. We believe it’s a valid concern ... but not right now.

Banks hoarding Fed’s generosity
The bottom line is that the Fed and other central banks have added massive fuel to their economic engines via quantitative (or “credit”) easing, causing a surge in the monetary base and the money supply. Through the Term Asset-Backed Securities Loan Facility (TALF), the Fed has begun a monetization program to provide up to $1 trillion of new credit to the financial system. In addition, the Fed will be buying $300 billion of longer-maturity U.S. Treasury securities, $750 billion of mortgage-backed securities, and $100 billion of direct debt of government-sponsored enterprises.

However, the Fed’s “generosity” isn’t getting into the real economy—the higher monetary base is simply keeping money supply afloat. Just as the public’s demand for money has increased, so too have banks’ demand for reserves. Had the Fed not satisfied both by creating more money, the economy would have suffered even more than it has. Let’s dive into how this all works.

High-powered money
“High-powered money” describes the monetary base—highly liquid money, including currency and vault cash. With the launch of the Federal Reserve System in 1914, it also includes deposit liabilities of the Fed to banks.

The monetary base is controlled by the Fed, which can print and release currency, or withdraw it through open-market transactions (buying and selling Treasuries). The Fed can also influence banking activities by adjusting interest rates or changing reserve requirements (how much money banks must keep on hand versus loaning out).

Fractional reserve banking explained
The monetary base is “high-powered” because the magnitude of changes in the monetary base can be greatly magnified by the “money multiplier.” That is, a small change in the monetary base can result in a large change in the overall money supply. As an example, a $1 billion increase in the monetary base will lead to an increase of many more billions in the money supply because of money multiplier effect of the fractional reserve ratio.

Example: If a bank has a “reserve ratio” of 10%, it can keep 10% of your $10,000 deposit and lend the rest ($9,000) with interest. The borrower will spend it somewhere and the money ultimately gets deposited again. From that new deposit of $9,000, the bank keeps $900 and lends $8,100, and so on. Ultimately your $10,000 can become up to $100,000 in the overall money supply ($10,000 divided by 10% reserve ratio). This is the “money multiplier.”

Money multiplier has imploded
Though money supply has surged (M2 growing at a nearly 19% annualized pace, a record) along with the monetary base (should reach $3.5 trillion by year-end), the money multiplier has plunged, which is not inflationary. The money multiplier is M2 divided by the monetary base; see all three components in the chart below.

Charts: M2/Monetary Base = Money Multiplier

Charts: M2/Monetary Base = Money Multiplier

Even if banks do boost lending, it should be offset for some time by the ongoing demolition of liquidity from writedowns and charge-offs. Banks are sitting on new reserves because they’ve lost confidence. Meanwhile, private sector demand for cash has jumped as renewed focus on balance-sheet repair puts savings back in the spotlight.

Fret deflation in the meantime
For now, deflation is the bugger. We think there are four reasons the current deflationary environment will likely persist at least as long as the recession: 1) Commodity prices have collapsed while past declines still work through the system. 2) Producers, wholesalers, importers and retailers were caught flat-footed by the lockdown of consumer spending and continue to unload surplus goods by slashing prices. 3) Wages are being cut broadly for the first time since the 1930s. 4) There’s a global surplus of aggregate supply, and inflation is plunging everywhere, including China, Japan and Europe.

Fret inflation later
There’s now enough slack in the system that if banks lent out the max amount of reserves, the public’s total money supply could increase by a factor of 10. It’s highly unlikely that the public would squirrel it all into savings without increasing spending. The onus is on the Fed to reverse course and tap the brakes by lifting rates and/or selling assets back to banks once growth accelerates. Some of that will happen automatically as short-term loans will expire.

How and when to react to an inflation threat will be more art than science. So far, Fed chairman Ben Bernanke is saying the right things. He knows that moving too early, as was done in the 1930s, will only elongate the pain and cause a further tailspin. He also knows that moving too late lets too much money generate too much inflation. He’s a student of the Great Depression’s mistakes—let’s hope that he heeds them.

Important Disclosures

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should pursue a particular investment strategy. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Examples provided are for illustrative purposes only and are not representative of intended results that a client should expect to achieve.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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