"Don't Know Much about Geography,
Don't Know Much Trigonometry,
But Sarah Palin Does Know Her Monetary Policy"
With apologies to Sam Cooke, Lou Adler and Herb Alpert
On November 8, 2010, Sarah Palin commented that the Fed's quantitative easing monetary policy was tantamount to printing money out of thin air. Sarah Palin may not know much about geography, but she does know her Fed policy. I would phrase quantitative easing a little differently. It is the Federal Reserve creating a specific amount of credit figuratively out of thin air. Theoretically, the Federal Reserve can create an unlimited amount of credit out of thin air. Of course, there would be dire economic consequences if the Fed were to create an unlimited amount of credit out of thin air. Under a fractional reserve system, the commercial banking system, the savings and loan system and the credit union system - systems of financial intermediaries whose liabilities include a means of payment - also are able to create credit figuratively out of thin air, but not an unlimited amount. The amount of credit that can be created out of thin air by these systems of financial intermediaries is ultimately limited by the amount of "seed money" or reserves provided them by the Federal Reserve.
So, Sarah Palin was correct about what is entailed in the Fed's policy of quantitative easing. Although Ms. Palin provided a public service in putting into plain language what quantitative is, she went on to question the wisdom of the policy. She wondered if QE2 might be followed by QE3, QE4 and QE5. She worried that the Federal Reserve might become not only the buyer of last resort for Treasury debt, but the buyer of only resort. This is a legitimate concern. After all, theoretically, the Fed is able to create an unlimited amount of credit out of thin air.
The late Milton Friedman also knew a few things about monetary policy. He wrote an essay for Stanford University's Hoover Institute in 1998 entitled, "Reviving Japan," in which he articulated a monetary policy prescription to pull the Japanese economy out of its post-bubble deflationary stagnation funk. To us, this policy reads a lot like the quantitative easing policy being prescribed by Fed Chairman Bernanke today to prevent deflation from taking hold in the U.S. and to help stimulate the demand for goods and services in the U.S. economy after the deepest and longest U.S. recession in the post-WWII era and the weakest U.S. economic recovery in the post-WWII era. Below is an excerpt from Friedman's essay. We will let you be the judge as to whether Friedman was prescribing quantitative easing for the Japanese economy in the late 1990s.
"The surest road to a healthy economic recovery is to increase the rate of monetary growth, to shift from tight money to easier money, to a rate of monetary growth closer to that which prevailed in the golden 1980s but without again overdoing it. That would make much-needed financial and economic reforms far easier to achieve. Defenders of the Bank of Japan will say, 'How? The bank has already cut its discount rate to 0.5 percent. What more can it do to increase the quantity of money?'
The answer is straightforward: The Bank of Japan can buy government bonds on the open market, paying for them with either currency or deposits at the Bank of Japan, what economists call high-powered money. Most of the proceeds will end up in commercial banks, adding to their reserves and enabling them to expand their liabilities by loans and open market purchases. But whether they do so or not, the money supply will increase.
There is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so. Higher monetary growth will have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately. A return to the conditions of the late 1980s would rejuvenate Japan and help shore up the rest of Asia."
Although the U.S. economy is not now experiencing outright deflation, the rate of increase in its consumer prices is quite low in an historical context (see Chart 1). In January, the U.S. CPI was up 1.63% from January 2010. In November 2010, when QE2 was publicly announced, the year-over-year change in the CPI was 1.14%, down from a recent high year-over-year change of 2.72% in December 2009 (see Chart 2). Along with a low rate of CPI inflation, U.S. house prices continue to decline on a year-over-year basis (see Chart 3).
Friedman noted that if the Bank of Japan followed his recommendation of quantitative easing, "[a]fter a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately." Yes, quantitative easing will result in higher inflation than otherwise. For Japan, the "otherwise" would have been continued deflation and tepid real economic growth. The Bank of Japan did not follow Friedman's advice and, in general, the Japanese economy has continued to experience deflation and tepid real economic growth.
What might inflation otherwise be for the U.S. if the Fed had not engaged in quantitative easing? As we mentioned, at the time QE2 commenced, CPI inflation was low, had been trending down and house prices were falling. What was the behavior of Milton Friedman's preferred measure of the money supply, M2 in November 2010, when QE2 commenced? Chart 4 shows that the year-over-year change in the M2 money in November 2010 was 3.14%, well below its 50-year average change of 6.90%. It is true that M2 growth spiked late in 2008 as corporations tapped their commercial bank credit lines for precautionary liquidity in the wake of the shutdown of the commercial paper market following Lehman's collapse in September 2008. But that was a short-lived phenomenon. With CPI inflation low and trending down, with house prices declining and with M2 money supply growth much below its long-run average, had QE2 not been started, the U.S. economy ran the risk of slipping into a deflationary stagnation much as Japan had after its asset-price bubble burst.
The stimulative and inflationary effect of quantitative easing should not be judged by looking at Fed credit alone. Rather, the total credit created "out of thin air" should be examined. If the Fed is creating credit but the commercial banking system is contracting an equal amount of credit, then the net amount of credit created out of thin air is zero - not very stimulative in terms of aggregate demand and therefore, not very inflationary. Regrettably, we have to wait for the Fed to provide us with quarterly flow-of-funds data for updates to the amounts of credit created by the savings and loan and credit union systems. Not until March 10 will the Fed publish these data for the fourth quarter of 2010. Fed and commercial banking system credit, however, are available weekly and monthly. Chart 5 shows the year-over-year percent changes in monthly observations of Fed credit, commercial banking system credit and the sum of the two categories of credit created out of thin air through January 2011. In the 12 months ended January 2011, Fed credit increased by 8.8%, commercial banking system credit increased by 2.7% and the sum of Fed and commercial banking system credit increased by 3.9%. To put this 3.9% combined Fed and commercial banking system into perspective, the long-run average change in this combined "thin air" credit since 1953 is 7.4%. So, to date, QE2 is not resulting in excessive "thin air" credit creation. Currently, faster growth in Fed credit is compensating for very slow growth in commercial banking system credit.
One of the most sensitive financial markets to expectations of inflation is the U.S. Treasury securities market. If QE2 were considered a major generator of future inflation, evidence of this would be reflected in this market. Chart 6 contains daily closing rates for the yield on a 10-year Treasury nominal security, the yield on a 10-year Treasury inflation-protected security (a TIPS) and the average percent change in the CPI over the next 10 years at which an investor would be indifferent between purchasing a 10-year Treasury nominal security or a 10-year TIPS - often referred to as the "break-even" expected inflation rate. The yield on the 10-year Treasury nominal security hit a recent low of 2.41% on October 6, 2010. QE2 commenced on November 3, 2010. On Friday, February 18, 2011, the 10-year Treasury nominal security closed at a yield of 3.59%. Thus, there was a net change in the yield on the 10-year Treasury nominal security of 1.18 percentage points between October 6, 2010 and February 18, 2011. Did the 10-year break-even inflation rate rise between October 6, 2010 and February 18, 2011? Yes, by 0.45 of a percentage point. The 10-year break-even inflation rate on October 6, 2010 was 1.89%; on February 18, 2011 it was 2.34%. Bear in mind, the year-over-year change in the CPI in January 2011 was 1.63% -- 0.71 of a percentage point lower than the 10-year break-even inflation rate. So, yes, with the commencement of QE2, the Treasury bond market's expectation of inflation has increased, but by less than one-half of a percentage point. Quantitative easing will result in higher inflation than would otherwise have occurred. But even at 2.34%, this still is a low rate of inflation in an historical context. Moreover, the 10-year breakeven inflation rate has yet to move higher than what it was prior to the onset of the last recession. If the yield on the 10-year Treasury nominal security increased by 1.18 percentage points between October 6, 2010 and February 18, 2011 and the 10-year break-even inflation rate increased by only 0.45 of a percentage point, what accounted for the remaining 0.73 (1.18 - 0.45) of a percentage point increase in the yield on the 10-year Treasury nominal security? The TIPS yield increased by 0.73 of a percentage point in this interval. Why? Perhaps, in part, because of expectations of higher Treasury credit demand as a result of the November 2010 Obama-McConnell federal personal tax rate compromise. If the Bush-era tax rate structure had been allowed to expire, the Treasury would not face as large borrowing requirements over the next 10 years as otherwise would have been the case. Another reason the TIPS yield might have risen is that non-Treasury credit demand might be picking up as a result of an improving economic outlook as a result of QE2.
Will there be a QE3? We suspect not, but do not really know. But we would offer a suggestion in how the Fed should decide whether to continue or cease a quantitative easing policy. Keep an eye on the growth in total credit created out of thin air. If there is no sign of a step up in combined credit growth from the commercial banking system, the savings and loan system and the credit union system, then a case can be made for a continuation in Fed quantitative easing. If there are signs of a meaningful pick up in this combined credit creation, then QE3 could lead to a higher rate of inflation that would be problematic to investors and the Fed.
With regard to the 2011 economic and interest rate forecast, our fundamental views have not changed since the January update. That is, we are forecasting faster real GDP growth and higher inflation than what occurred in 2010. We also are forecasting higher yields on Treasury coupon securities but no change in the Fed's policy interest rates. We are including are January 2011 forecasts in separate tables along with our February update. Since we published our January 2011 forecast, the Commerce Department published its advance estimate of Q4:2010 GDP-related data. Real GDP growth, according to this advance estimate was 3.2% at an annualized rate in Q4:2010 vs. our forecast of 3.6%. This put the level of Q4:2010 below what we had forecast and, thus, increased growth rate for our 2011 real GDP forecast. Our Q1:2011 real GDP growth rate also increased because of larger expected contributions from inventories and net exports than were assumed in our January 2011 forecasts. December 2010 and January 2011 CPI inflation came in higher than we had forecast - largely because of food and energy price increases, which all count in box score - has pushed up our 2011 CPI forecast. We believe that food and energy prices increases will settle down somewhat in the coming months and that "thin air" credit growth will remain sufficiently low to prevent other price components in the CPI from accelerating significantly. Our forecast of the unemployment rate for 2011 has been revised lower as a result of the sharp decline in the reported January unemployment rate. With regard to interest rates, higher-than-expected actual January and to-date February data have caused us to marginally raise our first-half 2011 interest rate levels for the Treasury 2- and 10-year securities. However, our second-half forecast remains the same.
THE NORTHERN TRUST COMPANY
ECONOMIC RESEARCH DEPARTMENT
SELECTED BUSINESS INDICATORS
*Paul Kasriel is the recipient of the Lawrence R. Klein Award for Blue Chip Forecasting Accuracy