In certain circles, talk of Quantitative Easing (QE) immediately triggers thoughts of Weimar Germany and Zimbabwe. The only beneficiaries of turning to the printing presses, it is suggested, will be wheelbarrow salesmen, whose product will become a useful ferry for wage packets. Whilst extreme inflation seems an exceptionally low risk event, there are legitimate concerns over the impact of the huge expansion of the monetary base on future inflation. In this Talking Point, we examine the key signals to watch out for in assessing future inflation risks.

Our key conclusions are:

·       Monetary base expansion in isolation is unlikely to drive higher inflation. Combined with an upturn in the velocity of money, however, QE has the potential for inflation to significantly overshoot current target levels in the medium term.
 

·       Whilst inflation expectations remain anchored around the current target inflation rate, driven by a perception of current easing conditions being temporary and faith in policymakers to successfully reverse the policy, we are unlikely to see the wage-price spiral encountered in the 1970s.
 

·       Policy error remains an important risk. Policymakers have a good theoretical understanding of the correct time to retract the expansion of the monetary base. In practice, economics is a complicated and muddled science, and policymaking is rarely as blissfully simple as the theory predicts.
 

·       In addition to policy error, the potential for financial repression to drive inflation, in the form of higher targets or greater tolerance of missed targets, is a nascent threat. The potential for QE to cause a relaxation in fiscal discipline is a medium-term worry.

“Inflation is always and everywhere a monetary phenomenon”¹

The grounding for inflation hawks concerned by the threat of QE is Fisher’s classic equation of exchange: MV=PQ² and the Quantity Theory of Money. Under the assumption that real output is independent of the supply of money, and V is stable, growth in M translates directly into growth in P, e.g. inflation.

The velocity of money ³, as the name suggests, simply describes how quickly the money in existence goes around the system, and the assumption of this being a stable ratio is patently untrue. If this doesn’t hold, the relationship between monetary growth and inflation will be far less than 1:1. For instance, were V to halve, even a doubling of M would leave the price level unchanged;  ceteris paribus. Clearly this is a gross simplification, but one that serves to highlight the importance of the velocity of money in the relationship between the money base and inflationary outcomes.

Consequently, any analysis of the growth in the money supply should also look at the velocity of money. Chart 1, below, shows the annual values of money base growth 4,inflation and velocity for the US over the past 80 years. Whilst the expansion in the monetary base via QE I and II is unprecedented, it has led to a huge decline in velocity ⁵. The monetary base of the US has at least doubled since the Federal Reserve (Fed) embarked on the first round of QE, but the velocity of money has fallen by around two thirds in this time.

 

 

The key question is at what point will the combination of the monetary expansion and velocity generate persistently higher inflation? Clearly, with such a huge expansion of the monetary base (over treble the 2007 level), a level of velocity well below 2007 levels could be consistent with a serious inflation headache for the Fed. 

So, what will drive a period of raised velocity and signal to policymakers to begin unwinding monetary easing? Both history and common sense suggest bank lending is a good barometer for the change in the rate of velocity. Whilst the relationship is not quite as strong in the UK, in the US it is very tight (see chart 2).

In the US we are beginning to see signs of recovery in this sector, with the final quarter of 2011 delivering the first positive year-on-year growth rate since midway through 2009. However, a quick glance at the scale on the left and right hand side of the chart suggests that we would need sustained and significant increases in lending to get velocity moving towards a level that would pose a serious inflationary threat.

Inflation expectations haven’t flinched

One of the most reassuring aspects of the ultra-loose policy is its lack of impact on inflation expectations. A rise in inflationary expectations, where the public expects inflation to persist at 5, 10 or even 15%, is a primary cause of insomnia for central bankers and can create the kind of wage-price spiral seen in the 1970s. If expectations do take root at higher levels, only a credible commitment by the central bank to deliver lower inflation can drive them back downwards. 

Unfortunately, as the early 1980s taught us, a hike in interest rates and a chronic subsequent recession is usually the only course back to low inflation with  sufficient credibility. Even after the great expansion in the monetary base, however, expectations remain well anchored in both the US and UK, using either market (the breakeven inflation rate) or consumer-led measures, as shown in overleaf in chart 3.

Whilst expectations remain stuck in the 2-3% range, policymakers are likely to remain serene about the medium term prospects for inflation. The reason that this huge increase in the money supply hasn’t translated into a surge in inflationary expectations is neatly summed up by Anderson et al. in a piece for the St Louis Fed “the key element is that inflation expectations are little affected by increases in central bank balance sheets that are perceived as temporary.”⁶

We would broadly agree with this summary. While the public retains faith in the integrity and ability of policymakers to reverse QE when appropriate, there is no reason to expect a sudden surge in inflation, and this can cause a selfenforcing virtuous cycle with low realized and expected inflation. Whilst this is a comforting thought, it is worth advising caution. This happy equilibrium, whilst looking resolute currently, is based on perception and subjective reasoning. Sadly, as economists all too often forget, the whims, fears and hopes of people can change quickly and for no apparent reason.   

Policy error and financial repression

Expected inflation remaining low relies on the faith people have in policymakers. Whilst we recognize their ability, a workman is only ever as good as his tools. A well thought out QE exit plan could still cause elevated inflation if untimely or inaccurate data delays its implementation. This is often the case in monetary policy, where an interest rate policy may be correctly set given the available data, but inappropriate given subsequent revisions. ⁷  We believe this to be one of the greatest dangers to inflation caused by the QE program, as data imperfections lead to its late unwinding after velocity has picked up sufficiently.

On a related theme, financial repression remains a lingering threat; either through an explicitly higher inflation target or greater tolerance of being above target. Comments to this effect from prominent voices, including the IMF’s current (Olivier Blanchard ⁸) and former Chief Economist (Ken Rogoff ⁹), suggest that whilst currently politically infeasible, these are measures being discussed at the top table of global economic policy. One only needs to look at the Bank of England’s record, where headline inflation has been at or above the 3% upper bound for the majority of the past two years, to see this in action.

 

Conclusions

In this analysis we have focused on the links from Quantitative Easing to inflation and have put aside other important drivers of inflation, such as a potential commodity super-cycle and the end of imported deflation/ disinflation from emerging markets. In the medium-term it is possible that, as a result of QE, inflation rates in the 5-15% range become the new normal. Equally, however, we show that it is possible to have a trebling of your monetary base and yet for inflation to tick along in the 0-5% range. 

The outcome we experience will have much to do with policy actions, monetary velocity and inflationary expectations. It is these areas that are likely to provide the earliest warning signs of where inflation may be headed over the longer term, and we would advise paying close attention to them. Our traffic light system based on these indicators suggests inflation is not a threat at present (see table 1). Current expectations and lending conditions seem more consistent with a lower range of inflation going forward but, given the fleeting nature of sentiment and expectations, caution would be advised against being too sanguine.

Discussion of hyperinflation, however, is both misguided and alarmist. Instances of hyperinflation are heavily linked to serious debt problems, where the authorities attempt to anaesthetise the pain with the printing press. The tipping point to hyperinflation comes when increasing the money supply is no longer an attempt to drive real economic activity (e.g. QE) but a deliberate means of avoiding difficult but responsible decision making.

 

Important Information:  

The views and opinions contained herein are those of Keith Wade, Chief Economist & Strategist and James Bilson, Economist, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. 

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1 Milton Friedman (1987)  The New Palgrave Dictionary of Economics.

2 Where M is the money supply, V is the velocity of money, P is the price level and Q is real output.

3 As with all monetary aggregates, the velocity of money is open to interpretation, but is generally accepted as the ratio of nominal GDP to the narrowest measure of the money supply.   

4 Defined as the St. Louis Adjusted Monetary Base; comprising the sum of currency (including coins) held outside of the Federal Reserve system and the US Treasury, plus deposits held by depositary institutions at Federal Reserve banks.  

5 Of course, this is because the money base is the denominator in the velocity equation. But had the numerator (nominal GDP) been sufficiently raised by an increase in the money base, velocity would not have fallen as low as it has. 

6 Anderson, Gascon & Liu “Doubling Your Monetary Base and Surviving: Some International Experience” Federal Reserve Bank of St Louis Review, November/December 2010

7 See Orphanides “Monetary Policy Rules Based on Real-Time Data” American Economic Review, September 2001

8 Blanchard , Dell’Ariccia & Mauro “Rethinking Macroeconomic Policy” IMF Staff  Note, February 2010

9 Rogoff “Embracing Inflation” The Guardian, December 2008

 

 

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