Here We Go Round the Mulberry Bush

Our PM in Japan (excerpt):

Malaysia asking for yen credit to help with national debt, says Dr Mahathir

MALAYSIA is asking Japan for credit as part of efforts to resolve its debt problem, Prime Minister Dr Mahathir Mohamad said today.

Speaking at a joint press conference with Japanese Prime Minister Shinzo Abe, Dr Mahathir said he was told Japan was considering the request.

“I have explained the financial problem faced by Malaysia, and towards solving this financial problem, I have requested for yen credit from Japan and Mr Abe, the prime minister, will study this request,” Dr Mahathir said.

I don’t have much time, so I’ll keep this short. I’ll give TDM the benefit of the doubt here – he could be talking about refinancing some of the USD debt under 1MDB, which makes sense since the yield on that debt was way above market. However, using JPY loans to cover MYR debt makes no sense at all.

OMG! QE3 To Boost Inflation…Not

The Federal Reserve Open Market Committee yesterday announced a third round of quantitative easing (excerpt; emphasis added):

FOMC Statement

…The Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that inflation over the medium term likely would run at or below its 2 percent objective.

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative…

Basically, the Fed is committing to increase its balance sheet size by USD85 billion every month – sounds like a lot, but its actually only about a 11.3% expansion of the Federal Reserve system’s USD2.8 trillion consolidated balance sheet from now until the end of the year.

(Details in the Fed’s plans are available here).

Quantitative Easing Versus Printing Money

Ooooh, this one’s a doozy. I know quite a few people who will blow a gasket (make that: the whole engine block) reading this (excerpt):

Deflation, debt, and economic stimulus
Richard Wood

The US, Japan, and Ireland are suffering from deficient private demand, rising debt, and a tendency to deflation. This column is asks what can be done about it.

We begin by assuming that relevant authorities have decided that new money creation is necessary to work against deflationary tendencies and to stimulate the economy. The central issue explored here then is how should such new money creation best be deployed to create the required economic stimulus?

Hyperinflation? Ain’t Happening

There’s a popular belief that’s been hanging around since late 2008 that the US and other countries that have engaged in quantitative easing a.k.a. money printing, are going to experience hyperinflation and currency collapses. If you’re not familiar with the term, it’s inflation on steroids, where currency losses its value faster than you can spend it, and where prices are higher in the afternoon than it is in the morning.

The most recent and historically extreme example of the hyperinflation phenomenon is of course Zimbabwe, which has come to symbolise economic and monetary mismanagement on an unbelievable scale. But hyperinflation is not just a disease of weak and developing nations. The other prominent example is the short-lived Weimar Republic, the government that replaced Imperial Germany in the aftermath of World War I. There have of course been lesser borderline cases in the past century, notably Argentina and Turkey, though inflation in those countries never reached the sublime heights it did in Zimbabwe and Germany.

Inflation? What Inflation?

I've spent the last couple days sitting in a seminar at INTAN on 1Malaysia. So far its been an interesting experience, with some good thoughtful speakers (as well as some not so good ones). There are some takeaways I'd like to talk about here, not so much on 1Malaysia but some of the nuggets that got bandied about, particularly on distributional issues. But this post will be tangential to that.

The seminar was supposed to be opened by the Chief Secretary to the Government yesterday, but due to a scheduling conflict, INTAN replaced the morning session with an impromptu 1hr talk by Lee Heng Guie, head of economic research at CIMB Investment.

No big surprises in his MY economic outlook - weak recovery in developed economies, and Malaysia should see positive growth in the second half of this year. He gave me some ideas that I'd like to follow up on statistically (US PMI as a leading indicator for MY exports for instance), but he repeated a stylized fact that is unfortunately all too common - quantitative easing (aka printing money) in the US will lead to higher inflation and a depreciating USD going forward. I'll buy (with reservations) the depreciating USD story, but inflation is by no means a given and its source will not be due to the Fed's liquidity injections or printing presses.

I'm seeing this high inflation story a lot in both the press and the blogosphere - this BusinessWeek article is one mild example of inflation hysteria (on a sidenote - Arthur Laffer is a prominent economist? Prominent maybe, but calling him an economist of any standing outside conservative circles had me choking).

You can get even more extreme drivel if you do a Google search for "libertarian gold nut" or Ross Perot. If I sound caustic on this subject, it's because I have little patience for a seriously outmoded form of monetary system that is so obviously economically unbeneficial (you can find my thoughts on gold here and here). Zimbabwe and the Weimar Republic frequently appear as models of comparison - as if the situations are at all comparable. The Fed is very far from triggering increased inflation, much less hyperinflation.

But what's wrong with the popular picture of QE driving inflation expectations? On the face of it, higher inflation is what we should expect: basic economic theory says that an expansion of the monetary base for a given level of output will necessarily turn up as an equivalent increase in the price level. As the saying goes, too much money chasing too few goods.

There's no doubt that the Fed, along with other major central banks have indeed conducted liquidity operations and QE on an unprecedented scale during the depths of the crisis. And under ordinary circumstances, this should indeed put upward pressure on the price level. The problem with this narrative is that it is essentially a static equilibrium analysis, which ignores two things:

1. The level of output has fallen below potential
2. The demand for money has increased

With slack in the economy, increases in the money supply will not cause inflation as both firms and workers lack pricing power. Firms can't increase prices without suffering loss in demand (and therefore profits), while workers can't demand higher wages in the presence of high unemployment. Also, under the present circumstances, firms and consumers prefer holding money rather than spending or investing it, which raises the amount of money supply that can be supported at a given level of output - again non-inflationary, as money velocity has fallen.

Most economists intuitively understand these factors, so much of the serious discussion is concentrated on what could happen after a recovery. If output closes on its long term potential and velocity rises back to its normal range in the next couple of years, won't the increase in the monetary base push inflation expectations along?

This is where the central banks' exit strategy becomes important. I've become far more sanguine on the ability of the Fed and ECB to unwind their balance sheet expansion than I was just a few months ago. There are a few reasons for my thoughts on this:

1. The monetary transmission mechanism is and will continue to be broken
The Fed's liquidity operations are not having an impact on the broader economy. The "massive" increase in the monetary base is not turning up as a corresponding increase in the broader money supply - the money multiplier has fallen. In fact M2 growth is hovering around its long term average of around 7% despite double-digit M1 growth (log annual changes; 1960-2009):



There are a few things going on here, of which the first is the increase in the demand for money I mentioned above. Secondly, banks are still recovering from the shellacking of the past year, and aren't that eager to lend especially as house prices are still trying to find a stable bottom and unemployment continues to increase. This situation is something that will in all probability take a few years to resolve, which gives time for the Fed to reverse its purchases of securities. Third is that the ongoing deleveraging of the shadow banking industry will continue to exert downward pressure on liquidity. And finally, the Fed (and a few other central banks) are using some unorthodox methods, which leads to my next point.

2. Paying interest on reserves
It used to be that banking reserves kept at the central bank attracted no income. This meant that banks would immediately utilise any excess over statutory reserve requirements, as reserves still had to be funded - reserve money was a dead loss. Now the Fed is paying overnight rates on all reserve funds, which means that banks should be indifferent to keeping their money in their reserve account or the money market. The importance of this is that the Fed can fine tune their control over the timing of shrinking their balance sheet. They don't need to mass dump securities on the market to mop up excess liquidity and potentially take a loss - they can raise the interest rate on reserve funds instead.

3. The Fed isn't actually printing money (at least, not so much you'd notice)
QE is such a bad couple of words that any hint of it has inflation hawks yelling blue murder. But how much monetization of government debt is the Fed actually doing? They have on their books just under US$700 billion, or something like RM2 trillion, worth of treasuries. On an absolute scale that sounds like a lot of money - it's rather larger than for example twice the entire M3 money supply of Malaysia. But scaled against the actual US national debt, it's somewhat less than massive at under 9% of estimated treasuries outstanding (held by the public) for 2009. If you include official holdings of treasuries, the ratio is even less. More importantly, the Fed is buying T-bills off the open market rather than at auction, so the effect on the monetary base is actually net zero and also has the impact of capping long term interest rates.

Based on these factors, I don't think monetary expansion will support a rise in inflationary expectations over the medium term - inflation is more likely to come about from elevated commodity prices. What I think will happen however is a general rise in interest rates, especially at longer tenures as the Fed only directly controls the 1 month rate.

I don't think the Fed has that much appetite for more QE than it absolutely has to - they're committed to another US$300 billion by September, but there's lukewarm support on the FOMC for continuing that program if I'm reading the signs right. And higher interest rates will also provide some notional support for the USD - which makes the USD collapse story less likely as well.

Technical Notes:
US money supply data from the Federal Reserve, estimates of US national debt from the Congressional Budget Office. The Fed's current holdings of treasuries is available here.