Inflation, Deflation, Interest Rates… What's going on?
I like to keep things simple, (my wee little noggin can only handle so much) thus I generally agree with the Austrian School of Economics definition of inflation, which is simply an increase in the money supply. As I mentioned in my piece on fractional reserve banking, an increase in the money supply, all else held constant, will result in an increase in prices across the board. This is rather intuitive if you think of money as simply another commodity. Imagine an economy in which the money supply is just $100 and there are only 30 apples and 20 bananas available for purchase every day. This economy can be easily modeled as
$100 = A * 30 Apples + B * 20 Bananas (where A is the price of Apples and B is the price of Bananas)
$100 = 30A + 20B
Since Apples and Bananas are the only items available for purchase in this economy, the amount spent on apples and bananas together must be $100. If the supply of money is doubled to $200, the equation would look like this.
$200 = 30A + 20B
Since the quantity of apples and bananas has remained unchanged, their prices (A & B) must go up.
So what’s all the talk about potential hyper-inflation these days?
Starting with the collapse of Lehman Brothers in September of 2008, the Federal Reserve more than doubled its balance sheet in only three months by financing its credit extensions using the electronic equivalent of printing money. At the beginning of September 2008 the Fed has $894 billion in assets, by December 17th that number rose to $2.24 trillion and now stands at $2.17 trillion. This unprecedented expansion resulted in an increase in the reserves credited to banks and a corresponding increase in the Fed’s assets. To create these reserves the Fed essentially purchased mortgage securities from the banks for 100% of the original loan amount by giving the banks credit for those mortgages in their reserve accounts as part of the bank bailouts.
As I mentioned in an early blog post, typically in the U.S. we see a 10x multiple on reserves, meaning for every $1 increase in reserves, we expect to see a $10 increase in the money supply. That has not yet occurred because for an increase in reserve funds to make their way into the economy, lenders need to be willing to lend against their reserves and borrowers need to be willing to borrow. With unemployment continuing at record high levels, households shifting from consumption to savings, and paying down outstanding debts, the demand for consumer loans is lacking. With corporations cautious about future expansions, commercial lending demands are also lower. Once demand for loans increases and banks are more confident in their own balance sheets, we could see significant increase in the money supply, which means inflation. The Fed claims to be watching for indications of this and have stated that they are willing to respond quickly by raising rates. An increase in the rate the Fed pays banks decreases the supply of money in the economy because banks and more willing to leave money in their reserves, earning interest from the Fed, rather than lending it out.
Now back to the Federal Reserve’s balance sheet. The loans the Fed “bought” from the banks are expected to be worth less than the original loan amount. Nearly 10.7 million households, or about 23% of U.S. homeowners owe more on their mortgages than the properties are worth. In addition, the states with the highest rate of underwater mortgages are, and most likely not coincidentally, non-recourse mortgage states, meaning borrowers are not held personally liable for more than the home’s value at the time that the loan is repaid. It is also highly unlikely that the Federal government will go after individual homeowners to recoup losses on underwater loans. This calls into question the quality of the assets owned by the Federal Reserve, which is of great concern to holders of U.S. debt. As we’ve seen the quality of sovereign debt globally come into question, the interest rate at which the United States is able to issue debt could rise if the perceived quality of our debt is lowered. With 71% of the marketable debt held by the public due by 2014 AND 40% individual income tax receipts already going to pay the interest on existing debt, an increase in interest rates on US debt could harm the economy, which puts the Fed in between a rock and a hard place when it comes to raising rates.
As of December 16th, 2009 the total outstanding public debt was $12.1 trillion while interest on the debt for 2009 was $383 billion (source Treasury Direct). Individual income tax receipts are estimated to be $953 billion for 2009, which means interest payments accounts for 40% of individual income tax receipts.
Data Source: Office of Management and Budget, Budget of the US Government FY 2010, Historical Tables, Table 7.1
Source: November 2009 GAO Financial Audit, Bureau of the Public Debt’s Fiscal Years 2009 and 2008 Schedules of Federal Debt (GAO-10-88)
