Are we crying wolf over inflation?

The FT has just published an op-ed from one Professor Jeremy Siegel of Wharton. In it, he predicts that the US is going to experience “an extremely inflationary economy in 2021,” where “inflation will run well above the Fed’s 2 per cent target, and will do so for several years.”

This is a contrarian position. The Federal Open Market Committee – the body at the Fed which sets monetary policy – does not project inflation reaching 2% until 2022. Professor Siegel joins the vocal minority warning about inflation.

December 2020 FOMC projections

Professor Siegel bases his argument on an old proposition: the Quantity Theory of Money (QTM). Simplified, it argues that the price level is a function of the quantity of money in an economy. If the quantity of money increases faster than output, all other things being equal, prices will rise.

The QTM has motivated previous inflation warnings. After the Global Financial Crisis, some warned that Quantitative Easing (QE), with its massive expansion of the money supply, would cause runaway inflation. The opposite happened, and the major macroeconomic puzzle of the last decade has been falling, not rising, prices.

Professor Siegel argues this time is different (always a red flag). QE created trillions in reserves, but it turned out banks were happy to sit on them, and not make loans, in part because the Fed began paying interest on excess reserves. Today, thanks to the stimulus checks, grants to local government, and the Paycheck Protection Program, money is “going directly into the bank accounts of individuals and firms.” Where before money wound up in bank vaults, this time it will get into the hands of private sector individuals and be spent.

As part of QE, banks exchanged their bond holdings for reserves, and then sat on them

Is that really the case though?

Siegel’s argument rests upon a distinction between the money held by banks as excess reserves, and the money now in consumer bank accounts; growth of the former had little or no effect on inflation, but growth in the latter will.

This raises the question of why money in a consumer bank account is more likely to be spent than bank reserves? Siegel suggests that liquidity requirements, and the interest the Fed pays on excess reserves, explains the tendency of reserves to accumulate. But if so, why should it be any different with consumers, who, as we all know, also receive interest.

The Fed started paying interest on reserves, and regulators imposed liquidity requirements that could be satisfied with these reserves. The banks easily absorbed the extra reserves created by the Fed and quantitative easing led to only a modest increase in lending.

But, why is money sometimes stashed under the proverbial mattress, and other times not? It seems unlikely the answer is directly related to how many notes are under the pillow. It is not enough to simply increase the money supply, you need people to want to spend it.

In fairness, the QTM does acknowledge this. In addition to the price level, the quantity of money, and a measure of real output, it includes a variable called the “velocity of money,” a measure of how often it changes hands.

M = quantity of money, V = velocity, P = price level, T = a measure of real output

High velocity looks like this. I pay you $100 for a bicycle, you use it to (under)pay your neighbor’s son to paint your house, and he spends it taking his girlfriend to a gauche mini-golf bar. In a low velocity world, I buy your bicycle, and you stash the money between the pages of your untouched copy of War and Peace. A healthy economy looks more like the former than the latter.

The problem is, if velocity is subject to unpredictable changes, then there can be no fixed relationship between quantity and the price level. Instead we must look to a third (or fourth or fifth) variable to explain why velocity changes. But, if one wants to posit a stable relationship between quantity and price level, as Professor Siegel does, then velocity must be relatively static in the short to medium term. Otherwise, price is conditional on the quantity of money, which is conditional on velocity, which is conditional on some other unknown. At best we could say the quantity of money is a necessary condition of inflation.

The point is to be skeptical of mechanistic explanations, especially ones first developed in the 18th century. The money supply is broadly correlated with inflation, but that does not mean they are causally related. Even if they were, it would not necessarily tell us the direction or magnitude of the effect.

Correlation or causation?

Let us also look skeptically on theories which avoid falsification tests and rely on verification. QTM theorists can always find historical episodes to verify their arguments. In fact, the allure of the “more money = more inflation” argument is that it is right eventually; at some point there will be inflation, and it is more than likely it will follow an increase in the money supply, if only because the money supply is usually increasing.

To paraphrase Paul Samuelson, inflation hawks have predicted 9 of the last 5 inflationary episodes. Despite this, the opinion pages of major newspapers always seem to find room for them.

It is unclear what would constitute a falsification of their hypothesis. Inflation failed to rise after the GFC, and a series of ad hoc explanations were provided. If inflation fails to increase in 2021, is that a definitive rejection of the QTM, or will more ad hoc explanations be appended to explain it away?

For the second time this week, I am reminded of the Marxists, who, when confronted by the failure of history to match their deterministic predictions (when is the revolution?), could always respond “not yet.”

We remain waiting.

The ECB’s December meeting – climate change and fiscal policy

The ECB’s Governing Council met yesterday for their monetary policy meeting. Its a similar story to what we have seen from other central banks in recent months: expansion of monetary stimulus and a verbal commitment that stimulus will stay in place for at least another two years.

Some technical decisions to take note of (skip to the next section if your eyes are going to glaze over at the mention of the PEPP, APP, and TLTRO III)

  • They are increasing the potential size of their Covid-19 quantitative easing program – The Pandemic Emergency Purchase Programme (PEPP) – by 500 billion, to 1.85 trillion. Importantly, they will continue to reinvest the principals from maturing securities until the end of 2023no attempt to reduce balance sheets until then. Put simply, as the bonds they hold mature, and the principal is returned, they will reinvest it in new bonds.

    The ECB’s other QE program – the Asset Purchase Programme (APP) – will continue at its 20 billion/month rhythm, with the principals also reinvested.

    On the question of winding down QE, Lagarde has said that interest rates will be raised (they are currently negative) before the balance sheet starts to be wound down.
APP refers to the ECB’s main QE programme – the Asset Purchase Programme
  • The ECB will improve the terms and conditions of its Targeted Long-Term Refinancing Operations (TLTRO III). The TLTRO programs have been around in various iterations since 2014. Their aim is to preserve the flow of credit by allowing bank to borrow from the ECB very cheaply – at negative rates in fact. Imagine the bank paying you for taking out a mortgage with them.

    To qualify for the special low interest rate, banks must meet two conditions. First they have to reach a certain lending threshold (quantity). Second, they must lend the money to non-financial corporations and households, although loans cannot be used for house purchases (quality). This is a very subtle form of credit direction policy

Some broader points from Lagarde’s press conference:

Fiscal policy and central banks

Lagarde reiterates her call for expansionary fiscal policy. Take note of the phrase “medium term.” That could be anywhere from 2-10 years. Its a big shift for a bank that was a driving force for austerity 8 years ago.

Climate policy and central banks

Lagarde has called out how important it is for fiscal stimulus and structural reform to focus on the green transition. Its only words, but it reflects how much the ECB under Lagarde has shifted on this topic. It’s hard to imagine the Fed or the RBA openly encouraging green spending.

More interesting is the question of the ECB’s QE program and the green transition. Central bank bond buying has never applied any ‘green’ criteria, they have bought trillions in corporate bonds/notes from polluters and non-polluters alike. Since polluters are often a larger part of the market, central bank asset purchases have often benefited polluting industries. There have been calls for some time now for central banks to incorporate green criteria into their bond purchase programmes, or even penalise the use of “brown assets” as collateral.

To date these proposals have been fiercely resisted, on the grounds it would make central banks too political. However, cracks are emerging within the normally monolithic central banking community. Lagarde has come out and said she thinks climate change has price stability implications. If accepted, this would allow central banks to justify action within their existing mandates. She also hinted that the ECB’s asset portfolio needs to be examined from a green perspective:

In addition, from Jan the ECB will be making slight changes to its bond buying criteria to allow certain ESG (Environmental, Social, Governance) bonds to qualify:

While the arguments of those who favor keeping monetary policy narrowly focused do have some merit, it is time we began to openly debate them. They rely on the pre-crisis hope that monetary policy could be a neutral force and conveniently ignore all the political decisions made since the crisis.

If governance arrangements developed in the 1970s mean central banks can no longer deliver what is required of them by society, let’s re-examine the former, not under-deliver on the latter.


YCCATRBA almost sounds like a cool new hip hop track no?

But it’s even better: Yield Curve Control at the Reserve Bank of Australia


At the Reserve Bank of Australia’s (RBA) December 1st meeting they voted to keep all policy options unchanged. This includes its target of maintaining 0.1% on three year Australian government bonds, a policy also known as Yield Curve Control (YCC).

YCC was first announced in March, with the RBA committing to buy any quantity of Federal Government and semi-government (e.g. state government) securities required to reach its yield target. The target was set to 0.25 in March, and lowered to 0.1 in November.

One of the concerns about YCC is that the commitment is open-ended. If investors got skittish and started selling bonds, causing yields to rise, the central bank would have to step in and purchase potentially enormous quantities of bonds.

The alternative approach is the quantitative easing practiced overseas, where the central bank commits to buying a certain quantity of bonds, but does not commit itself to achieving a set target for yields. This limits the central bank’s commitment.

In both cases the goal is to shift portfolios to other assets and reduce borrowing costs. The question is which requires the central bank to do less?

RBA Government Security Purchases
Purchase DateQuantity
(Billions AUD)
Total (Billions AUD)Purchases as a % of outstanding long-term government securities
October0.063.0No data on outstanding securities
November5.068.0No data on outstanding securities
Data drawn from the RBA outstanding debt securities database and purchases announced in monthly monetary policy decision press release.

Still, this quick and dirty calculation suggests the RBA has been able to anchor long-term rates quite quickly at minimal cost.** This is good news for advocates of YCC, especially when you consider that QE has left the Fed and the Bank of Japan with bond holdings in excess of 30% or 40% of GDP.

Lets quickly take a look at this from the Government’s perspective (drawing on the Australian Office of Financial Management’s data). We see an increase in long-term security issuance from April, just after YCC began. At the same time, short-term security issuance starts to decline from May. In other words, the government is taking advantage of the RBA’s effort to keep longer term borrowing costs down and loading up on longer-term debt.

Interestingly, this surge in issuance does not seem to be putting pressure on the RBA’s peg. Between May and July, the government raised nearly $100 billion in long-term debt. I do not have data showing breakdowns by maturity, but presumably some quantity of that was 3-year debt. Despite the increase in issuance over the period, the RBA did not need to purchase more bonds to maintain its peg.

There is clearly plenty of demand for government debt right now. The risk is that if private demand for public debt at that price were to decline (for whatever reason), then the RBA would need to purchase ever larger quantities of the debt to maintain the peg. For now, that does not look like a concern.

As I’ve said before, the government should take advantage of this to borrow for an ambitious investment program. I remain skeptical of stimulus overly reliant on tax write offs and incentives.

The RBA separately announced a more traditional $100 billion QE program last month, with 19 billion already purchased. I will revisit these figures once more data on debt issuance becomes available.

*A small purchase was made in May but it did not change the overall quantity, so was probably below $1 billion in size. June and July had no purchases.

**The calculation is not perfect because I don’t have data on how exactly the RBA is spreading its purchases along the yield curve, and whether they are also purchasing short-term treasuries.

A busy week of central bank announcements

Fair warning, this is going to be a wonky post. (If you’re unsure what asset purchases or quantitative easing is and you’re wondering why in the world i keep talking about it, see this explainer.)

This week was a big one for acronyms. The Fed’s Federal Open Market Committee (FOMC) and the Bank of England’s Monetary Policy Committee (MPC) met on November 5th. The Reserve Bank’s Board (surprisingly no one calls it the RBB) met two days earlier on November 3rd. These are the respective committees at each central bank that make decisions on policy like interest rates or quantitative easing.

Bank of England

The BoE kept interest rates at 0.1% and added an additional £150 billion in government bond purchases, taking the total stock to £875 billion. In their words:

The Committee does not intend to tighten monetary policy at least until there is clear evidence that significant progress is being made in eliminating spare capacity and achieving the 2% inflation target sustainably.

The BoE predicts inflation will be back at 2% in two years time. Given the potted history of central bank inflation predictions, this should be taken with a grain of salt. Still, policy looks set to stay incredibly accommodative for at least two years.

Reserve Bank of Australia

The cash rate was lowered to 0.1% and $100 billion in new government bond purchases was announced. The RBA is also one of the few central banks in the world to do Yield Curve Control (YCC), where they commit to keeping the yield on a certain category of bond (in this case a 3-year Australian Government) at a certain rate. It is an open-ended commitment to buy any quantity of bonds required to achieve the target rate, which is 0.1%. In simple terms, the Australian Government can take out three year loans at 0.1% as long as the RBA keeps this policy in place. How long will policy stay like this?

For its part, the Board will not increase the cash rate until actual inflation is sustainably within the 2 to 3 per cent target range. For this to occur, wages growth will have to be materially higher than it is currently. This will require significant gains in employment and a return to a tight labour market. Given the outlook, the Board is not expecting to increase the cash rate for at least three years. The Board will keep the size of the bond purchase program under review, particularly in light of the evolving outlook for jobs and inflation. The Board is prepared to do more if necessary.

Its important to note that while the cash rate is staying where it is for at least three years, the RBA might wind back its bond purchases or YCC. Either way its an incredible commitment, especially given inflation has been so subdued globally for the last decade.

Federal Reserve

The Fed switched to average inflation targeting this year. Instead of just apologizing for missing their inflation target, the Fed will now attempt to average out past inflation performance. Put simply, if the target is 2% and inflation averaged 1% between 2010-2020, then inflation needs to average 3% between 2020-2030. It is a little more complicated because the Fed has not been explicit about what periods they will use, how they will calculate the average, or how high they will let it go, but that’s the basic premise. Here’s the relevant part of the statement:

With inflation running persistently below this longer-run goal, the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer-term inflation expectations remain well anchored at 2 percent. The Committee expects to maintain an accommodative stance of monetary policy until these outcomes are achieved.

The Fed kept interest rates where they were, 0-0.25%, and will continue to purchase bonds at the current pace of $120 billion a month.

Chairman Powell continues to emphasise minorities and low-income groups:

The economic downturn has not fallen equally on all Americans, and those
least able to shoulder the burden have been hardest hit. In particular, the high level of joblessness has been especially severe for lower-wage workers in the services sector, for women, and for African Americans and Hispanics

Powell’s appeals for more fiscal stimulus come at a time when the prospect of a Republican Senate and Democrat President make new stimulus increasingly fraught:

As I have emphasized before, these are lending powers, not spending powers. The Fed cannot grant money to particular beneficiaries. We can only create programs or facilities with broad-based eligibility to make loans to solvent entities with the expectation that the loans will be repaid. Many borrowers are benefiting from these programs, as is the overall economy. But for many others, getting a loan that may be difficult to repay may not be the answer. In these cases, direct fiscal support may be needed. Elected officials have the power to tax and spend and to make decisions about where we, as a society, should direct our collective resources

So what?

Monetary policy looks set to be incredibly accommodative for at least two more years, possibly longer should inflation continue to be stubborn. What are the implications?

  • Financial stability risks: The longer monetary policy is accommodative, the greater the financial stability risks. This is no secret and banks have macroprudential policy (MPP) tools at their disposal. Still, MPP is a newish field and there are still questions about the best approach.
  • Will monetary policy continue to crowd out fiscal policy? Over the last five years or so, central banks have become increasingly vocal about the need for fiscal stimulus. Covid-19 finally forced open the purse strings, but its an open question how long it will last. Before the second wave, the UK Chancellor was already talking about debt, and the austerity hawks are never far from the opinion pages of the Australian or the Washington Post. Will the commitment of three years of super expansionary monetary policy make it easier for governments to take their foot off the gas?

    There is no easy solution to this problem, in part because its the result of the system working as intended. Independent central banks were partly set up as a check on fiscal policy, and to take as much discretionary macroeconomic policy out of the hands of elected politicians as possible. We are now in the awkward position where the politicians have learnt the lesson too well, and are happy to hand off macroeconomic management to central banks.
  • No one knows what monetary policy normalization will look like: The Fed’s asset portfolio is north of $5 trillion, the ECB’s €3 trillion, the BoE almost £1 trillion. Japan is another universe; the Bank of Japan’s portfolio is bigger than Japan’s GDP. (The chart below is pre-Covid, so the numbers are actually significantly higher – the Fed has added almost a trillion in asset purchases this year.)

    The point is that these numbers are so large they are probably impossible to eliminate, especially because central banks have been clear that QE is now a standard part of counter-cyclical policy. To date it looks as if central banks holding nearly 50% of their government’s outstanding debt is fine? In fact central banks regularly insist these holdings are “market neutral.” The point is, we’re in a Wild West where the only thing we know is that the limits of the past were figments of our collective imagination or a world that now lives only in history books. This is good news for progressives.
From the WSJ