Why this is different to post GFC – “This money will catch fire”

Posted | 12/05/2021 / Views | 1382
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The warning drums of the implications of this unprecedented monetary stimulus experiment are growing louder and louder.  Some draw on historical precedent, some draw on the realities of math, and some just plain old Economics 101 of supply and demand.   Most of the current commentary on the implications leads to fears of inflation, of which the Fed is trying to convince us will be ‘transitory’.  There certainly is evidence to suggest the peak of it may well be, but the pressures of still much higher support beyond that peak remain.  There are also those who are saying inflation fears from when QE first came to be in 2008 never played out.  That is correct in traditional CPI terms but look at financial assets amid a moribund economic recovery… Ask the top 10% if they enjoyed ‘inflation’ since the GFC….

More fundamentally however, the construct this time is very different to that of post GFC.   Famed financial commentator for London’s The Telegraph, Ambrose Evans-Pritchard, writes insightfully to this and is worth reading in full as follows:

“US inflation fears mount as the Fed ‘monetises’ Biden’s deficits

The US Federal Reserve and Treasury are repeating one of the most disturbing episodes of the 1940s and risk stoking a destructive inflationary boom, a leading monetary watchdog has warned.

The Centre for Financial Stability (CFS) in New York says US money supply data are flashing a red alert and that excess reserves in the banking sector threaten to set off an “explosion of lending” as the recovery accelerates.

The Fed is riding a tiger by the tail and may have great difficulty extricating itself from a torrid monetary experiment that is reaching its limits.

The CFS said its “divisia” measure of the broad M4 money supply rose 24pc in March from a year earlier, and its M1 variant rose 36.9pc. “Those monetary growth rates are potentially alarming,” said Professor William Barnett, the institution’s director.

Prof Barnett said de facto collusion bet-ween the Fed and the Treasury is much like the 1940s, when the Fed served as a fiscal agent for Democratic administrations and mopped up the vast bond issuance needed to pay for World War II and its aftermath.

Inflation reached 17pc by mid-1947 and creditors were gradually expropriated in what amounted to a stealth default stretched over several years.

The US output gap has already closed and Joe Biden’s $6trn fiscal plan is expected to push economic growth above its pre-pandemic trajectory by next year. Five-year “breakevens” measuring inflation expectations have jumped to 2.71pc, the highest since the pre-Lehman boom. Yet the Fed is continuing to buy $120bn of bonds each month.

The situation is fundamentally different from waves of QE after the global financial crisis.

Stimulus at that stage was needed to offset a contraction of the money supply as banks slashed lending and sought to beef up their capital ratios to meet tougher Basel rules.

Today’s QE is monetisation of fiscal deficits and is leading to a surge in bank reserves. This money will catch fire if monetary velocity returns to normal as the economy recovers.

The Bank for International Settlements — the venerable club of global central bankers in Basel — also fired a shot across the bows last Thursday, warning that it would be a grave error for policymakers to let rip on monetary growth in the hope that social inequalities could be cured with inflationary stimulus.

The poor tend to suffer most when consumer prices suddenly start to rise.

“We should not forget the long-lasting scars of uncontrolled inflation on inequality. History abounds with episodes of high and runaway inflation that increased poverty and inequality via sharp reductions in real wages,” said Agustin Carstens, the managing director of the BIS.

The story of US financial repression in the 1940s ought to be a warning for bondholders. The Fed under Marriner Eccles capped yields in order to stabilise the financial markets while the Roosevelt administration was running eye-watering budget deficits. It was justified at first as a patriotic necessity in the fight against fascism but proved hard to stop, continuing into the late 1940s when the rationale was no longer clear.

This experiment with fiscal dominance led to a bitter dispute between the Fed and the Truman administration, ultimately leading to the Treasury-Fed Accord of 1951. This deal restored the operational independence of the central bank. But by then the compound effects of double-digit inflation had fleeced long-term debt holders.

This bond restructuring by stealth was highly successful in one sense: the US federal debt ratio fell from a peak of 120pc of GDP in 1945 to around 70pc a decade later, and yet further with the Great Inflation of the Johnson-Nixon years.

Prof Barnett from the CFS said there are grounds for suspecting that the Fed is surreptitiously playing the same trick today: converting what is supposed to be a temporary injection of liquidity into permanent monetisation, while pretending that inflation is a remote concern.

But in doing so it has fallen into a trap of its own making, since it pays interest on excess reserves to commercial banks as a side-effect of modern QE. This means it will have to pay them more as rates rise, at which point the institution might require recapitalisation by the Treasury to avoid sinking below water.

This would precipitate a political storm in Congress.”