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Why is US Inflation Low-VRK100-04Oct2013

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Why is US inflation low despite US Fed flooding the economy with printed money and having kept the interest rates at zero bound? RamaKrishna Vadlamudi, Hyderabad, analyzes the reasons behind the low inflation.
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    Rama Krishna Vadlamudi, HYDERABAD 04 October 2013  www.ramakrishnavadlamudi.blogspot.com  One question that tickled my mind in recent months was why the US inflation islow even though the US Federal Reserve has flooded its economy with fiat money. I’m no expert on economics. Nor do I have any great understanding of the dynamics of the US economy. Anyway, let me make an attempt.  What is Inflation?Inflation rates go up when prices go up. Too many dollars are chasing lesserquantity of goods and services pushing up their prices. As prices rise, the value of  your money falls. One of the key factors influencing inflation is money supply (  See notes 2 to 8 below ). Other factors could be expectations, fiscal deficit,economic activity, investment by firms, wages and others.“Inflation in a fiat money world is difficult to suppress,” opined Alan Greenspan,the former chair of the US Fed. Fiat money or fiat currency is simply papermoney printed by a central bank on behalf of a government and released to theeconomy. One important feature of fiat money is that the governments haveenormous power to create or destroy this paper money. For several decadesthough, the world has been experiencing a very large creation of paper money, but not its destruction.    www.ramakrishnavadlamudi.blogspot.in 04 October 2013  Page 2 of 5 The dynamics of the world economy have changed enormously and in several ways in the last two to three decades. Inflation has, more or less, remained low inmany advanced economies, like, the US, the UK and the eurozone countries. Forover two decades, Japan has suffered deflation—decrease in price levels. In thelast six months or so, the Asian giant seems to be coming out of deflationary trends after Japan decided to double its monetary base.The Standard Medicine in the US: What does the US Fed do in order to stimulate a weak economy? In normal times,the Fed eases monetary policy by lowering its target for the short-term policy interest rate, the federal funds rate. And to tame inflationary pressures, the Fedraises short-term interest rates, which makes the money costlier to borrow. Thisis the standard medicine.The US has zero-bound interest rates (federal funds rate of 0 to 0.25 percent)since December 2008. Theoretically, the record-low interest rates would havestimulated credit growth and resulted in a gradual increase in inflation. But noneof this has happened in the US in the last five years since the global financialcrisis.Inflation is always and everywhere a monetary phenomenon, said notedeconomist Milton Friedman. His argument was that to contain inflationary pressures, you’ve to first restrain the money supply. However, using this tool tocontrol inflation is considered blunt. Interestingly, the importance of money supply in stoking or subduing inflationary pressures has diminished in the US inthe recent past (  See notes 7 and 8 below ).    After the 2007/2008 global financial crisis, the Fed has been trying to stimulatethe US economy with its easy money policy. As part of the quantitative easing(QE) program, the Fed has been buying bonds as it cannot lower its interest rates below the present 0 to 0.25 percent. As a result of the unconventional QEprogram, the monetary base in the US has gone up by almost four times in thelast six years or so.  Related:What are Fed Tapering and Quantitative Easing? 19Sep2013    But the US inflation rate has been at an annual average of around 1.5 percent inthe past five years. When the monetary base has gone up four times and theinterest rates have been kept close to zero percent in the last five years, why isthat the US inflation rate has been below the US Fed’s comfort level of twopercent?The Answer is:1. The money pumped in by the US Fed has reached banks. But the banks areholding the funds as excess reserves, instead of lending them; and these reserves    www.ramakrishnavadlamudi.blogspot.in 04 October 2013  Page 3 of 5   are again kept with the Fed! Of late, the Fed has been paying interest on thesereserves to banks and other financial institutions.So, the banks find it more attractive to receive interest from the Fed rather thanlend to households or businesses. The lending is not happening as the economy is weak. It’s no surprise that the growth in the US national income too is below twopercent in recent years and unemployment rate continues to be at more than 7percent.2. The US households’ savings rate was close to zero percent prior to 2008, butnow it’s anemic at around three to four percent of GDP. Household debt was very high prior to 2008. After the global financial crisis, wage incomes are down formany millions of US citizens.They want to save more rather than spend their money. The US households have been focused on reducing their debt, rather than increasing personalconsumption. Consumer consumption growth is a dominant factor in the USeconomy. Of late, consumer consumption growth too is anemic at less than twopercent. So, the deleveraging continues in the US economy resulting in low inflation, while the unemployment rate continues to remain at elevated levels.3. The balance sheets of many US companies are very healthy and they are awash with liquid money. As they aren’t sure about the prospects of US economy,they’ve been using their excess cash to repurchase (buyback) shares rather thaninvest in new plant and machinery or creating new jobs.The tech-giant Microsoft has announced a $40-billion share buyback recently.The company has increased its dividend also. Companies, like, Apple, Merck, GE,Home Depot, Time Warner and 3M, too have offered/undertaken share buybacksin the past six months to one year.Relation between money supply and inflation becomes tenuous now:Evidence in the past indicated that there was a strong connection between money supply and inflation rates. But history need not repeat itself. This strongconnection becomes tenuous now, at least in the US. (  See notes 7 and 8 below ).The US Fed has been preparing the world markets for unwinding of its assetpurchases, by floating “balloons” since May this year, when they first talked abouttapering. When the markets reacted violently—after the talk of tapering started—resulting in the steep decline in prices of bonds, shares, commodities and largescale outflow of funds from the emerging markets; the Fed, the ECB and the IMFtried to assuage the markets by communicating that they would continue theireasy money policies as long as the economic growth remains weak. At the same time, the Fed wants the unwinding of highly risky and leveredpositions in the markets. (It may be recalled the easy money available in the US    www.ramakrishnavadlamudi.blogspot.in 04 October 2013  Page 4 of 5 and other nations moved to commodities and non-US markets, especially emerging markets, for achieving higher yields).Between May and the middle of September this year, many such highly leveredpositions have already been unwound. Now that the markets have already experienced this fall due to talk of tapering; the market’s future reaction may bemuted once the Fed starts actual tapering of its bond buying program.Finally:It is inevitable that the US interest rates have to go up one day. It won’t be asurprise if the inflation rises in the next 12 to 18 months above the US Fed’scomfortable level of two percent. The world is deluged with dollars printed by theUS Fed. Investors have borrowed money at lower rates in the US and invested themoney in emerging markets and others in their quest for higher yields. As wehave seen in the last four months, the unwinding of levered bets has createdproblems not only for the emerging economies, such as, India and Indonesia (  Seenote 9 below ); but also to investors themselves.The US banks have to start lending their excess reserves once the US economy picks up momentum and the demand for money grows. The concerns that theinflation in the US and other developed world will rear its head once again aregenuine.Related: What is US government shutdown and debt ceiling limit? 27Sep2013  Emerging markets down but not out 10Aug2013   References : US Fed FAQs; “The Age of Turbulence” by Alan Greenspan  Photos above are courtesy of US Fed. Left is Marriner S Eccles Bldg of the Fed and right is Fed board room.Disclaimer: The author is an investment analyst, equity investor and freelance writer. This write-up is for information purposes only and should not be taken as investment advice. Investors areadvised to consult their financial advisor before taking any investment decisions.  ------------------------------------------------------------------------------------------------ Notes: 1. The US Federal Reserve (US Fed) is the central bank of the US
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