The Great Inflation: Money Factors

Background

The structure of the postwar international monetary system was designed at a conference of leading countries in 1944 at Bretton Woods, N.H. Under the resulting agreement, countries other than the U.S. agreed to maintain the value of their currencies within a very narrow band in relation to the U.S. dollar and to the price of gold. The U.S. agreed to value the dollar at $35 per ounce of gold, to be convertible on demand by other governments. In effect, this agreement tied the domestic as well as the international monetary system of the U.S. to gold since the U.S. was not free to follow a policy that would undermine the commitment to maintain a dollar value of $35 per ounce of gold.

In the decades following this agreement, a postwar dollar shortage in other countries was replaced by a dollar glut as other countries rebuilt their economies and boosted their exports. Persistent U.S. balance of payments deficits led to redemption of dollars into gold despite numerous efforts by the U.S. to avoid them. From 1958 to 1971, the U.S. lost about half of its gold reserves to $10 billion. In August 1971, the U.S. ended further redemptions, bringing the fixed exchange rate system to an end. The value of the U.S. dollar henceforth was determined by buyers and sellers in world markets. Other currencies were also "floated" in this manner.

The importance of these actions cannot be overstated. Their significance is brought out in the following words of Federal Reserve Governor Lawrence Meyer in a speech this January at Swathmore College:

"And now we are finally at a system with the ultimate discretionary power of monetary policy. We've got fiat money that the government sort of creates, so no backing of commodities [like gold], and we've got flexible exchange rates. No restraint imposed on monetary policy. We have the ultimate in discretionary policy and all of a sudden, now central bankers really become important. Because now discretionary policy is what determines the price level and inflation, and that depends on the judgments and decisions made by central banks around the world. So central banks had to learn how to exercise that discretion. And government had to learn how to give mandates to central banks, and tell them what kind of objectives to have - typically price stability, in the U.S. promoting price stability and full employment..."

[Chart data derived from Economic Report of the President and Statistical Abstract]

This graph shows that while output at constant prices rose about four-fold, at current prices it rose about nineteen-fold or over four times as much. This result certainly makes one wonder whether central bankers really did "learn how to exercise that discretion". And, more importantly, what have been the consequences of that result?

Monetary Policy

The Fed has two primary tools for implementing monetary policy. The first is the targeted federal funds rate, and the second is the level of required reserves.

The federal funds rate is the tool familiar to media commentators and the general public. Federal funds are bank reserves that are sold by banks with excess reserves to banks that need more reserves to meet their required level. They are sold on a one day basis for a specific rate of interest. The Fed Open Market Committee can influence this rate by buying or selling large blocs of Treasury securities, which either increases or decreases the volume of bank reserves in the banking system. The presumption is that a low federal funds rate (indicating ample or even excess reserves) will encourage banks to expand their loan volume. The federal funds rate also influences other short-term interest rates including the prime rate of commercial banks.

Despite the media attention to the federal funds rate, on a historical basis its primary relationship is to the volume of currency in circulation as shown in the following graph:

U.S. currency now consists entirely of federal reserve notes, and these notes also constitute the vault cash of banks which count as reserves in satisfying the required level of reserves set by the Federal Open Market Committee. When cash is withdrawn from banks, reserves are depleted and the Fed replenishes them by purchasing U.S. securities. Thus the process of matching the amount of U.S. securities held by the Fed with the amount of Federal Reserve notes in circulation is automatic and constant. At the end of 2000, U.S. securities held constituted 83.4% of Fed assets, while Federal Reserve notes outstanding constituted 94.0% of total liabilities.

It will be noted from the chart that currency in circulation approximately doubled each decade since 1970. Much of this increase has been due to currency taken out of the U.S. - 47.5% or $251.8 bn at the close of 2000. This reflects the use of the dollar as a world currency for international commerce as well as lack of confidence in many other currencies. All currency in circulation represents an interest-free loan to the U.S. Treasury since the interest paid on U.S. securities held by the Fed is almost all returned to the Treasury.

In summary, contrary to popular assumptions, Federal Open Market Operations, over a long period, respond to demands for currency but do not control the expansion or contraction of the economy.

The second tool the Fed has to conduct monetary policy is its authority to raise or lower the level of required reserves of depository institutions. This is a powerful tool since it immediately expands or contracts the level of bank credit. Historically, banks have been required to maintain a reserve equal to a percentage of their demand deposits (checking), savings deposits, and other time deposits (CDs etc.). In 1980, for example, these requirements were as follows:

By 2000 these requirements were as follows:

Thus, the requirement on savings and time deposits was eliminated in this period, a significant change. The overall level of reserves in relation to deposits over the past 40 years is shown in the following graph:

In 1950, reserves (Fed balances plus vault cash) equaled 20 percent of deposits, whereas in 2000 they equaled only one percent of deposits. In effect reserves at the Fed are nearly as low as they can go, since substantial amounts are needed for clearing operations.

It will be noted that the gap between deposits and reserves widened enormously from 1980 to 2000. In addition to required reserve cuts in the 1980s, two factors contributed to this change. The first was the elimination of the 3 percent required reserve on savings and time deposits in December 1990 when the economy was in recession. It should be viewed as part of the rescue operation to aid the banking system to recover from its losses incurred in the commercial real estate market. It was also the period in which the S&Ls had to be bailed out with over $100 billion in public money by the government.

The second factor was the development of swap accounts by banks since 1994, described as follows in the Federal Reserve Bulletin (4/99):

"---Under these programs, depository institutions shift their customer's funds from checking accounts that are reservable into special purpose money market deposit accounts that are not reservable. Thus, depository institutions can decrease the level of their deposits subject to reserve requirements and, with no change in their vault cash holdings, their total required balances on which they earn no interest.

The consequence of these repeated reductions can be seen in the following graph comparing the growth of real GDP (output) with the growth of the money supply (M2, M3).

The result is much like what we found in comparing real GDP with nominal GDP-the money supply grew about five times more than actual output, and most of the gap came after 1980. During 2000, M-3 grew at one of the fastest rates on record while output was falling, a most unusual divergence.

The key to understanding the connection between lower required reserves and money growth is the money multiplier, which can be illustrated by an example. Let us assume that banks must maintain a 50 percent reserve against deposits. If Bank A makes a loan of $100, it creates a deposit of an equal amount. If the owner of this deposit buys a TV and pays for it by issuing a check to the vendor, who deposits it in Bank B, the following occurs: Bank A's deposits go down but Bank B's deposits go up. Bank B must maintain a 50 percent reserve against the new deposit but can use the other 50 percent to make a new loan. This process continues in a progression as follows: $1000 - $500 - $250 - $125 - $62.50 - $31.25 - 15.66 etc. The essential point is that every new deposit has a limited potential to expand the money supply. On the other hand, if there is no required reserve, the potential expansion is unlimited. In this case, the banks would determine the money supply, while the Fed would be little more than a bystander. Thus, the expansion of the last two decades is a result of the low level of required reserves.

Aside from their effect on the money supply, low reserves create a potential danger in case of systemic breakdowns such as that in the early 1990s or the 1930s. If the banking system were overwhelmed with bad debts, the Fed could not help them much by further reserve cuts (which immediately frees bank funds for investment in earning assets such as Treasury securities) because present levels are little more than those required for clearing purposes plus currency demands. The U.S. Treasury would then be the only rescue recourse available, as deposit insurance would be inadequate in a systemic crisis.

We have now reviewed how changes in the monetary system made it possible for the money supply to grow roughly five times more than output in the past 40 years, an economist's prescription for inflation. But the inflation we have experienced has not matched the expansion of the money supply, and competition, which tends to restrain price rises, has been intense in the economy. To reconcile these divergent trends, we need to examine the structural changes that have impacted the economy in recent decades. This will be our next endeavor.

The five economies experienced substantial downturns in 2001, with Germany and Japan in outright recession. Industrial production was down except in Germany. Retail sales picked up in Canada, the UK, and the U.S., emphasizing that consumer spending was not a major factor in the downturn.

Economic weakness did not avert another rise in consumer prices except in Japan; in Britain the price level has now doubled in less than 20 years. Unemployment rates rose in Canada, Japan and the U.S.

Central banks have sought to offset the downturn with increased liquidity through lower interest rates. Whether this will rescue the capital investment sector - the source of weakness - will be one of the fascinating questions in 2002. If the tactic fails, the only thing left will be massive public spending.

Nothing emphasizes the world slowdown more than the stock indices. Losses abroad ranged from 15 to 20 percent, but the US Dow declined less than 10 percent; it was the second year of declining prices, however. With exceptionally low interest rates and declining stock prices, speculation has become the only game in town.

The Japanese current account surplus continued to shrink in 2001 while the U.S. deficit fell for the first time since 1995. Canada and Germany experienced surpluses, the U.K a deficit. In the prevailing conditions the U.S. dollar strengthened considerably against major trading partners. Apparently, the U.S. is still considered the preferred domicile for investment funds.

The growth god faltered rather badly in 2001 as GDP rose only 1.2 percent. Disaggregating this number shows clearly the source of weakness:

Personal consumption expenditures increased in each quarter whereas investment spending fell, and net exports slumped because of similar weakness in other countries.

Industrial production was down only moderately, but the utilization rate fell to its lowest reading since 1983. Business equipment has led the downturn. Manufacturers' new orders fell to the lowest level in three years.

New construction, however, continued to surge. Residential housing led the increase, but commercial and industrial expenditures declined. The median price of new single family homes reached $169,000 in 2000, up from $64,600 in 1980 and $122,900 in 1990. Real gross private investment fell in 2001 even though it includes residential housing. The areas that turned down include nonresidential equipment and software, and private inventories, which declined after many years of increase.

Not surprisingly, manufacturing and trade sales have fallen since the middle of 2000 whereas retail sales continued to advance. Manufacturing and trade sales were impacted by the downturn in investment spending whereas retail sales were stimulated by tax refunds and tax cuts. Interestingly, however, the retail inventory sales ratio fell (161 to 148) more than the manufacturing and trade ratio (143 to 139).

Another factor supporting the retail sector was an additional rise in real personal consumption expenditures to $22,559 from $22,152. A moderation in consumer price inflation contributed to this result.

The long uptrend in nonagricultural employment faltered in 2001 at the 132+ million level, and by February 2002 had declined to 131.3 million. Goods producing industries fell 0.6 million in 2001 while services employment increased 1.0 million (in contrast to increases of 3.0 million in recent years). Government employment rose 0.2 million. The slowdown across categories within services was pretty general. The effect of actual declining employment on consumer income and spending will show up during 2002.

National income rose in 2001, but the rate of growth was less than half that of the last five years. Lower corporate profits was the primary factor in the decline. Per capita disposable income rose as much as in the preceding year, while average weekly earnings rose a little more than in 2000.

Gross saving fell after many years of increases. Business and government saving declined, but personal saving rose, bolstered by tax rebates received in the third quarter.

Commodity prices fell even further from the low levels of the prior two years; both food and industrials shared the weakness. Producer prices rose for the year but were in decline after September; crude materials were weakest at an index of 95.5 by December.

Corporate profits fell sharply from the middle of 2000 to the lowest level since 1998. This, combined with the low capacity utilization rate for total industry, indicates there will be no near term pick up in capital investment, the source of current economic weakness. Low short and long term interest rates also indicate that there is weak demand for funds for investment. Congress may further distort depreciation rules to encourage investment, but it is definitely clear that this may not achieve its objective.

The M-3 money supply, at 12.8 percent, grew at the fastest rate since 1981, and more than twice the rate of non financial debt. With inflation staying low, this growth seems, again, to be standing conventional economic theory on its head.

One of the conventional economic theories has been that from 6 to 9 months after the Federal Reserve reduces interest rates, the economy responds by moving up. We are now in a position to test this contention. In 2000, the Fed raised its target rate from 5 1/2 percent to 6 1/2 percent while in 2001, it reduced the rate from 6 1/2 percent to 1.75 percent. The purpose was, by forcing down the interest rate through increased open market operations, to increase bank lending. The result for the two years is as follows:

Total new lending not only fell to its lowest level in years in 2001, but one of the weakest sectors was commercial and industrial loans - the very sector the Fed hoped to stimulate. The role of interest rates is vastly overrated. If profit prospects are strong, businessmen will pay even high interest rates, but if profit prospect are weak, low interest rates will not entice them. A good example is Japan where even zero short term rates do not stimulate spending of any kind.

Consumer credit expanded strongly in 2001 but well below the exceptional pace of 2000. Credit market debt grew 6.0 percent in 2001 compared with 5.0 percent in 2000 and 6.8 percent in 1999. Household debt grew at the same rate as in recent years, but business debt growth fell to 6.0 percent, the lowest since 1986.

The current year will prove crucial in sorting out these divergent trends. If weakness spreads to other sectors of the economy, we may find ourselves at a historic turning point in which the future will bear little resemblance to the recent past.

The U.S. balance on goods and services improved a bit in 2001 as world trade in non automotive capital and consumer goods slumped. Trade in services declined mainly due to lower travel and passenger expenditures.

U.S. capital flows abroad slowed from 2000's high level to approximately the same as in 1999. Foreign inflows, however, slowed proportionately less resulting in a larger net change in the U.S. international investment position; this change is now approaching almost half a trillion dollars per year.

Foreign purchases of Treasuries turned positive while purchases of government-backed and private securities matched the 2000 level. One of the big questions going forward is whether this high level can continue. One danger is that the Japanese will have to unload their dollar holdings as conditions worsen at home. Any reversal of foreign capital inflow will reduce the exchange value of the dollar and possibly initiate trade conflicts.

Copyright © Andrew Caughey, 2002

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Published 2 May 2002