The Federal Open Market Committee (FOMC) just issued its latest statement on monetary policy. The federal funds target rate will remain the same for now. The Fed will also continue to roll off $30 billion per month in assets by allowing them to mature without reinvestment.
The biggest news out of the statement is a slight word change from the previous statement. The current (May 2, 2018) statement said that “both overall inflation and inflation for items other than food and energy have moved close to 2 percent.” In the previous statement in March, it said that “both overall inflation and inflation for items other than food and energy have continued to run below 2 percent.”
In other words, the Committee’s statement is showing expectations of slightly higher consumer price inflation. As long as the economy keeps humming along, this will justify the Fed further hiking its target rate in the future, as well as staying on the path of reducing its balance sheet.
It is interesting that price inflation is picking up, albeit very slightly. This is in the face of monetary deflation. If the Fed’s balance sheet is being reduced by $30 billion per month, and it is only supposed to increase this reduction in future months, then why are consumer prices rising at an increasing rate?
The first thing to consider is that prices take time to adjust throughout the economy. When new money is issued, or money is withdrawn, as is being done now, it is mostly through the banking system. It is not as if your checking account is going up or down in any immediate way based on the Fed’s monetary policy. It takes time for money to change hands and to ultimately bid up prices (with inflation) or bring down prices (with deflation). It can take many months, or even years, before new money makes its way into the economy and settles in place.
The second thing to consider is that the Fed is generally looking at consumer prices and not so much asset prices. Asset prices have already been roaring, especially when it comes to housing and stocks. Since stocks are not accounted for in their price inflation measurements, we don’t always know if there is a shifting of resources.
A third thing to consider is that the money supply is just one factor in determining prices. The loans issued by banks play a major role in whether the adjusted monetary base is multiplied through the fractional reserve lending process. This was one of the main reasons that price inflation stayed relatively tame during the Fed’s great monetary expansion from 2008 to 2014. Much of the new money that was created ended up as excess reserves held by banks. In other words, the banks did not lend out this money. With the Fed having increased the interest it pays banks on their reserves, you would think that this would just curtail bank lending that much more, but we can’t be certain of this.
We must also factor in the demand for money. If the demand for money is high, then this will be the equivalent of a deflationary force. Another way of saying this is that the velocity of money is low. This means that money changes hands less frequently, and therefore does not bid up prices as fast. The high demand for money can offset some of the monetary inflation trying to push prices higher.
It could be that people are finally getting over the financial crisis from nearly 10 years ago and have more confidence in spending money. Therefore, we could be seeing a slight pickup in velocity (a reduced demand for money), despite the current monetary deflation.
The productivity of an economy can also impact prices, but I don’t think that is playing a big factor either way today. If the money supply were held constant over a long period of time, we would expect to see prices fall very gradually over time as productivity increases. You would have the same number of dollars (or whatever kind of money) chasing a larger portion of goods and services.
Since there are so many factors going into consumer prices, it should not be surprising that there is currently a slight disconnect between consumer prices and the Fed’s balance sheet (the base money supply).
Still, we should not expect this to continue for a really long period of time. While some gains in the last decade in productivity are real and sustainable, I do believe that part of it is also unsustainable. The Fed’s easy money policy from 2008 to 2014 misallocated resources that still need to be corrected.
As the monetary deflation takes its effects, these malinvestments will be exposed. I expect stock prices to be hit hard at some point, and I expect a major correction. When this happens, it will not be surprising to see price inflation expectations fall, at least until the Fed comes in with another round of massive money creation to start the whole cycle over again.