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Weekly Economic Commentary

 
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The link between money and inflation has clouded, but it hasn’t disappeared

April 25, 2014

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I am a child of America’s Rust Belt. My father designed equipment for steel mills; I can still smell the soot that perfumed his overcoat when he came back from a business trip. The Museum of Science and Industry was just a few blocks away, and I spent many hours there marveling at the manufacturing exhibits.

But then, forty years ago, the price of oil began to surge. This development began a slow, painful decline for the heaviest industries in the United States. Factory hulks can still be found across much of the Midwest, sad monuments to what had been the source of our economic might. Another remnant left by the oil shocks was runaway inflation, which neared 14% in 1980.

I was attending the University of Chicago at that time, where I was taught that the persistence of inflation had less to do with the prices of commodities and much more to do with the growth of the money supply. Belief in that lesson has left me struggling to understand why inflation has been falling recently in spite of massive growth in reserves. At some point, these two elements should revert to their long-term alignment. The questions are: when, and how?

The expansion in the American monetary base since 2008 has been unprecedented. Waves of quantitative easing have nearly sextupled the size of the Federal Reserve’s balance sheet. And yet annual inflation (as measured by the deflator on personal consumption expenditures) is running at less than 1%.



Monetary policy impacts economic activity with long and variable lags. So it is not as if the translation of ease to inflation is instantaneous. During the present cycle, this translation has been weakened by a couple of factors.

a) As shown in the first panel above, the money supply has grown much more slowly than the monetary base. Money supply carries the stronger empirical link to inflation.

As we’ve discussed in the past, slow growth in bank credit explains the divergence. Whether due to recalcitrant borrowers, heightened regulation or apprehensive financiers, loan growth has been very modest since 2009 and idle reserves have accumulated on bank balance sheets in huge amounts. This results in a steep decline in the velocity of money.

As we discuss in the following piece, bank lending has shown signs of accelerating so far this year, which should slow and eventually reverse the decline in velocity. As that happens, the money supply should grow more rapidly and, potentially, begin to pressure inflation.

b) Our current expansion, now almost five years old, has been very weak when compared to its predecessors. The result is a reservoir of idle resources that holds down costs. The best example of this, of course, is in the U.S. labor market: broad measures of unemployment remain extraordinarily high and wages have grown very modestly during the expansion to date.



It will likely take some time to return to full employment. And since labor is a significant driver of overall costs (especially in service industries), bottom-up pressure from this source should remain modest.

For the near term, Fed Chair Janet Yellen has shared the view that we are at greater risk for persistently low inflation than we are for a return of high inflation. If and when price pressure begins to develop, the Fed feels that it can address the problem as it arises. Those worried about rapid increases in prices have been characterized as living in brick houses and still worrying about termites.

Alan Meltzer, a historian of the Fed (and sometimes its critic), disagrees. Meltzer has observed that rapid increases in money, wherever they have occurred, always lead to rapid inflation. And the magnitude of the Federal Reserve’s current quantitative easing program is unprecedented.

To reduce unemployment without triggering an unpleasant rise of inflation, the Federal Reserve will have to manage the behavior of banks carefully. Financial institutions are earning only 25 basis points on their deposits with the Fed, so their incentive to search for yield is powerful. Reducing this incentive will require raising interest rates by enough to encourage banks to leave their excess funds where they are; such an increase might have to be sizeable.

The Fed is already getting some criticism for not keeping a lid on long-term interest rates, which are taking some steam out of the housing market. And then there’s the matter of the carrying cost on the national debt, which fiscal policy makers would like to keep under tight control. While independent, the Fed would certainly face a good deal of external pressure to stay easier for longer, which was the policy that created high inflation 35 years ago.

We certainly do not foresee inflation ranging that much higher in coming years, and we think the Fed retains the lessons of the Volcker years. But the lessons I learned as an undergraduate suggest that we not dismiss the risks of rapid money growth, for we do so at our potential peril.

Bank Lending to Businesses – Pipes Are Unclogged, Need We Worry?

Bank lending contracted sharply during the Great Recession, reflecting the impact of impaired bank balance sheets. The turnaround in total bank lending commenced only in the third quarter of 2011, a little more than two years after the economy recovered.

Today, the volume of loans to businesses is approaching the peak seen in the last business cycle, thanks to strong growth in 2014 to date. The intuitive question that follows is whether excesses comparable to those prior to the financial crisis are developing once again in bank lending.

Retail establishments, factories and other businesses use commercial and industrial loans to financing of inventories and for investment in equipment by. Commercial and industrial loans outstanding at $1.65 trillion are roughly $4.3 billion below the peak seen in 2008.



Commercial real estate loans extended for activities such as construction of buildings and land development turned the corner only in the first quarter of 2013, following an extended period of contraction that began in the early months of 2009. Commercial real estate loans outstanding touched $1.5 trillion in the first quarter, as compared with the peak of $1.8 trillion in 2008.

Underwriting standards for commercial and industrial loans are favorable and support loan growth. The Senior Loan Office Survey indicates that terms for both commercial and industrial loans and commercial real estate loans have eased, and anecdotes from the field suggest that deals are being structured and priced very aggressively. In this environment, it is entirely conceivable that bankers will be less cautious and engage in a lending boom.

Delinquency rates on bank loans continue to decline. Write-offs related to the recession are virtually done. But as the old bromide goes, you don’t make bad loans in bad times. You make bad loans in good times.

Fed officials likely have mixed feelings at recent readings on lending. While credit growth is positive for economic growth, a controlled pace that limits the potential for excess is highly desirable. Unfortunately, the credit channel is very difficult to fine tune.

For now, the growth in business lending remains constructive. Recent gains are clearly making up some lost ground. However, lenders and the Federal Reserve must manage the advance carefully.

High Frequency Trading – Boon or Bane?

The rationale behind high frequency trading (HFT) is not new; it is the story of exploiting arbitrage opportunities and facilitating market-making. Yet the spotlight is back on HFT with media coverage of the Michael Lewis book Flash Boys. The dust has not settled on the debate about costs and benefits of HFT, but here is a summary of the key issues.

HFT is a type of automated trading based on mathematical algorithms; it is among the tools used to apply trading strategies. The primary feature of HFT is rapid calculations and execution speeds.



A large investment in technological infrastructure enables success of the HFT model, as it involves executing transactions with thin profit margins in very large volumes. Estimates vary, but there is a consensus that about 50% of equity trading in the United States consists of HFT and an approximately similar share is reported for Europe.

There are two schools of thought about the impact of HFT. Advocates of HFT stress the narrowing of bid-ask spreads, the speed of execution, increased liquidity, reduced volatility, and lower transactions costs for market participants as benefits of HFT. Each of these outcomes enhances the quality of markets.

Critics of HFT cite that efficient allocation of capital requires more than just taking advantage of price aberrations visible due to technological sophistication. In the old days, market participants consisted of institutional investors (who invested on behalf of financially challenged individuals saving for retirement, rainy days, and other emergencies of life) and retail investors. Enter HFT, bringing a new class of market participants for whom fundamentals matter little.

Another grievance is that HFT gives firms a technological advantage that allows them to “front-run” orders. The possibility of market manipulation is an additional drawback: HFT enables the introduction of orders not meant to be executed, which can lead to incorrect quotes. There are numerous variations of this strategy that may compromise the quality of the market.

Regulators in several jurisdictions are actively seeking to mitigate the risks of HFT. The goal of regulation should be to ensure that integrity and confidence in markets is not compromised. At the same time, regulators need to appreciate the positives of HFT and not create unnecessary barriers to the working of the free market system.

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The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.
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