Inflation: Definition & Effects on Rates

[BilPrestonEsq]

Yes, so let me get this straight...So a bank say Bank of America they loan out 90% of there reserves for morgages and whatever else-debt or debt instuments as they call it. The Fed comes along and takes on some of this debt and replaces it with cash. They liquidate the debt in other words. Hmmm so 90% of the cash that I put in the bank becomes a debt on their books which they are making money on(through interest on loans). QE2 is a way to take that debt and turn that debt which is actually 90% mine and everyone else's money with a checking account and turn that into more money. And then that money is used to loan out to someone else creating new wealth. Is that about right? So in a way it's 'watering down' the currency that's already in circulation? Because there is a certain amount of money, debt or liquid that's out there and then the Fed makes money by using debt to make more debt for someone else and then if the economy is slow and people aren't spending than they just liquidate that debt so that money can be loaned out to create wealth. So my money is used to create money that makes my money less valuable as there is more money in circulation? Unless of course the economy is growing and how can it not be growing with all the goods that we export in the U.S.? Do Chinese blue chips offer good dividends?

 

[WhoWee]

That is true. But once again, what is the mechanism to explain the devaluation of the US dollar as a result of QE2? And is there evidence that such devaluation occurred between today and, say, mid-September, especially on a scale that would explain a 12% jump in dollar-denominated oil prices in the same period of time?

We've clearly over-simplified the relationship. To address your question specifically, we'll need to investigate currency prices and everything that effects the price of oil. This would include oil production and supply, futures trading, distribution logistics, taxes, any unseen impacts from the BP spill (clean-up, insurance, fines, new requirements?) or other industry issues, any pending legislation, and a multitude of other variables.

 

[talk2glenn]

QE2 is a way to take that debt and turn that debt which is actually 90% mine and everyone else's money with a checking account and turn that into more money. ... So my money is used to create money that makes my money less valuable as there is more money in circulation? Unless of course the economy is growing and how can it not be growing with all the goods that we export in the U.S.?

The debt isn't "turned into" anything; it is sold. The buyer is the Federal Reserve, and the seller is a private intermediary (like a bank).

To the debtor, the process is transparent - you continue to service the debt through a middle-man (a bank or debt processor, usually the party that originated the loan), who insures that the holder of the debt instrument (bond or security) is payed. If the government owns the debt, then they are paid. This effectively absorbs some of the new currency issued by the Fed automatically over time, a point you seem to be missing. Any profits (interest paid on outstanding loans minus losses from bad debt) is paid automatically to the US Treasury, but this is money received by the central bank in excess of the amount original lent out to the economy.

Think of the central bank as just another lender on the marketplace. It just has the exclusive authority to create new currency with which to make its loans - everybody else must compete for currency on the currency markets.

The value of your money is constantly fluctuating according to conditions on the currency market, independent of any action by the central bank. Indeed, the central banks mission (in addition to macroeconmic stability in the United States) is currency stability; they try to protect the consistency of your currency's value over time.

 

[WhoWee]

The debt isn't "turned into" anything; it is sold. The buyer is the Federal Reserve, and the seller is a private intermediary (like a bank).

To the debtor, the process is transparent - you continue to service the debt through a middle-man (a bank or debt processor, usually the party that originated the loan), who insures that the holder of the debt instrument (bond or security) is payed. If the government owns the debt, then they are paid. This effectively absorbs some of the new currency issued by the Fed automatically over time, a point you seem to be missing. Any profits (interest paid on outstanding loans minus losses from bad debt) is paid automatically to the US Treasury, but this is money received by the central bank in excess of the amount original lent out to the economy.

Think of the central bank as just another lender on the marketplace. It just has the exclusive authority to create new currency with which to make its loans - everybody else must compete for currency on the currency markets.

The value of your money is constantly fluctuating according to conditions on the currency market, independent of any action by the central bank. Indeed, the central banks mission (in addition to macroeconmic stability in the United States) is currency stability; they try to protect the consistency of your currency's value over time.

Normally when you puchase debt - you try to purchase it at a discount - correct?

That is not the strategy here.
http://dealbook.nytimes.com/2011/01/11/the-feds-qe2-traders-buying-bonds-by-the-billions/

"They are buying hundreds of billions of dollars of United States Treasury securities on the open market in a controversial attempt to keep interest rates low and, in the process, revive the economy, Graham Bowley reports in The New York Times.

To critics, it is a Hail Mary play — an admission that the economy’s persistent weakness has all but exhausted the central bank’s powers and tested the limits of its policy making. Around the world, some warn the unusual strategy will weaken the dollar and lead to crippling inflation."

 

[BilPrestonEsq]

The debt isn't "turned into" anything; it is sold. The buyer is the Federal Reserve, and the seller is a private intermediary (like a bank).

To the debtor, the process is transparent - you continue to service the debt through a middle-man (a bank or debt processor, usually the party that originated the loan), who insures that the holder of the debt instrument (bond or security) is payed. If the government owns the debt, then they are paid. This effectively absorbs some of the new currency issued by the Fed automatically over time, a point you seem to be missing. Any profits (interest paid on outstanding loans minus losses from bad debt) is paid automatically to the US Treasury, but this is money received by the central bank in excess of the amount original lent out to the economy.

Think of the central bank as just another lender on the marketplace. It just has the exclusive authority to create new currency with which to make its loans - everybody else must compete for currency on the currency markets.

The value of your money is constantly fluctuating according to conditions on the currency market, independent of any action by the central bank. Indeed, the central banks mission (in addition to macroeconmic stability in the United States) is currency stability; they try to protect the consistency of your currency's value over time.

If I say the debt is liquidated is that better for you. Debt-liquidated. What does that mean to you?

You are failing to make the connection here. There is debt- a promise to pay an obligation. Liquid asset- as good as cash. That is 'turning' a promise to pay cash into cash. You are liquidating debt. That creates money out of nothing. That debt is an obligation to pay- its not yet paid. So how does that have no effect? How is that transparent? If the debt is sold to the Fed(the lender of last resort) that means there is more debt that money! Prove that wrong. Unless of course growth can catch up right? How can you catch up if the whole economy is based on spending? If we didn't have all of our goods shipped in from China we would have crumbled a while ago.

 

[BilPrestonEsq]

Normally when you puchase debt - you try to purchase it at a discount - correct?

That is not the strategy here.
http://dealbook.nytimes.com/2011/01/11/the-feds-qe2-traders-buying-bonds-by-the-billions/

"They are buying hundreds of billions of dollars of United States Treasury securities on the open market in a controversial attempt to keep interest rates low and, in the process, revive the economy, Graham Bowley reports in The New York Times.

To critics, it is a Hail Mary play — an admission that the economy’s persistent weakness has all but exhausted the central bank’s powers and tested the limits of its policy making. Around the world, some warn the unusual strategy will weaken the dollar and lead to crippling inflation."

I think it says it all right there.

 

[WhoWee]

The question should be this - what happens when the Fed raises the rate?

http://www.freddiemac.com/pmms/pmms30.htm

The historical norm is approximately 8% - we've been hovering between 4% to 5% since the January 2009.

 

[BilPrestonEsq]

Bringing the interest down gives people more incentive to buy a house in this market hopefully raising the value. Wow 16% in 81-82.

 

[WhoWee]

Bringing the interest down gives people more incentive to buy a house in this market hopefully raising the value. Wow 16% in 81-82.

As compared to 4.69 last year (2010) - their strategy is not obvious (to me at least?).

 

[BilPrestonEsq]

Yea maybe that answer was oversimplified. Lowering the rates does have that effect on people looking to buy a home though. How much lower can it get? I have an idea put it at -4.69. That would work! It would be nice to see a graph with all pertinent numbers layed out with important historical events in the timeline. Maybe over the last 300 years, that sounds like a pretty ambitious project though

 

[talk2glenn]

Normally when you puchase debt - you try to purchase it at a discount - correct?

The Federal Reserve does not behave like a normal market participant. You are correct - when a profit-motivated individual attempts to purchase debt, he tries to do so at the lowest price (and highest yields) possible. This is what allows the interest rate markets to reach equilibrium.

Central banks do not use a profit-maximizing strategy; they use a first come first serve strategy without regard to whether or not the debt it is being offered is a "good buy". This provides an incentive for banks to try and unload their "bad debt" onto the central bank, and also for banks to move quickly (since it is first come first serve). Both of these enhance the stimulative effects of the boards strategy. The central bank can, however, target particular debt instruments or particular debt holders, depending on circumstances. For example, at the height of the crisis the central bank targeted mortgage backed securities. In QE2, it targeted Treasury bonds.

If I say the debt is liquidated is that better for you. Debt-liquidated. What does that mean to you?

From the perspective of the original bond holder (the bank, for example), the debt is "liquidated" in the sense that he has sold the bond and purchased cash. From the perspective of the debtor, the status of the debt is unchanged; he continues to make regular payments in accordance to the contract terms - he is no more or less liquid than he was before. From the perspective of the central bank, currency has been sold and bonds purchased - the central bank is less liquid.

Is this more clear?

 

[BilPrestonEsq]

It was a rhetorical question.

 

[WhoWee]

From the perspective of the original bond holder (the bank, for example), the debt is "liquidated" in the sense that he has sold the bond and purchased cash. From the perspective of the debtor, the status of the debt is unchanged; he continues to make regular payments in accordance to the contract terms - he is no more or less liquid than he was before. From the perspective of the central bank, currency has been sold and bonds purchased - the central bank is less liquid.

Is this more clear?

They are printing the cash - correct?

This might explain the strategy behind suppressing the interest rate for so long.
http://www.creditwritedowns.com/2010/10/on-liquidity-traps-and-quantitative-easing.html

"Normally, the U.S. Treasury must sell bonds when there is a budget deficit. The principal reason that the Treasury could not just print money out of thin air (what Murray Rothbard calls counterfeiting) is because the Federal Reserve needs them to control supply and demand of Fed Funds in order to maintain its target interest rate above the interest rate on reserve balances.

However, when interest rates are zero percent, the Federal Reserve doesn’t have this problem. There is no difference between the Fed Funds rate and the rate on reserve balances."

 

[WhoWee]

From the same link, Paul Krugman offered this:

"When the Fed Funds rate is essentially zero, the Federal Government does not have to issue any bonds at all (except as mandated by Congress to ‘fund’ deficit spending). In reality, when rates are zero, the Fed could simply monetize the deficits and it would be functionally equivalent. What this means is that there is no difference between quantitative easing and issuing short-duration treasury bills. Paul Krugman recently pointed this out in an essay, saying:

The point is that we’re now in a liquidity trap. What does that mean? It means that the Fed has pushed short rates down to zero, so that at the margin T-bills are no better than cash — and correspondingly, that means that at at the margin people and banks are holding some of their cash purely as a store of value. Liquidity is now free, and as a result the market’s demand for liquidity is satiated; adding more potentially liquid assets makes no difference. So issuing short-term debt and printing monetary base are equivalent.

But, you say, it won’t always be thus: at some point the economy will recover to the point where the zero lower bound is no longer binding; and at that point monetary base and short-term debt will no longer be the same thing. Indeed. But at that point the Fed will be seeking to reduce the monetary base — by definition: it’s only once the Fed is trying to curb the size of the base that the zero lower bound ceases to be binding."

 

[talk2glenn]

They are printing the cash - correct?

Correct, in principle. However, their capacity to print currency is subject to the markets demand for dollars; it is not unlimited. So the Federal Reserve's capacity to inject additional currency (forget the source) is diminished. The Federal Reserve does not have infinite leeway to buy bonds and sell currency - at some point it will so deflate the value of its new currency (and inflate the value of bonds) that nobody will be willing to trade bonds for dollars.

From the same link, Paul Krugman offered this:

Krugman is essentially correct - the Federal Reserve is effectively monetizing the debt. The government removes currency from circulation to finance its deficits. The central bank turns around and removes Treasury bonds and replaces them with currency. This is not a bad thing - indeed, it is extremely stimulative. The question becomes: is the central bank the sole enabler of government debts? The answer is no; there is market demand well beyond that of the central bank for Treasury's.

It is also correct that there is no functional difference between Treasury Bonds and dollars at real interest rates of zero percent. It is not the case, however, that real interest rates are zero. Clearly there is market demand for loanable funds in excess of the supply; banks are holding cash not as a store of value but as a hedge against risk.

 

[hamster143]

Krugman is essentially correct - the Federal Reserve is effectively monetizing the debt. The government removes currency from circulation to finance its deficits. The central bank turns around and removes Treasury bonds and replaces them with currency. This is not a bad thing - indeed, it is extremely stimulative.

Only the first part is extremely stimulative. These are essentially two independent processes and QE2 refers only to the second part.

edit: to be exact, the stimulative part is where the government uses currency removed from circulation to finance its operations, injecting it back into circulation. So, for each $1 removed, $2 are injected. Therefore monetization of debt leads to the increase in money supply.

It is also correct that there is no functional difference between Treasury Bonds and dollars at real interest rates of zero percent.

at nominal interest rates of zero percent.

 

[talk2glenn]

Only the first part is extremely stimulative.

Deficit spending is stimulative. Quantitative easing is stimulative. Together, they are extremely stimulative. This is why QE2 specifically targeted government bonds - the Fed was acting very deliberately. So yes, the two are inexorably linked by circumstance.

at nominal interest rates of zero percent.

Nominal and target rates aren't relevant; market interest rates (real rates) are the calculus used in a profit-maximizers decision making.

 

[hamster143]

Deficit spending is stimulative. Quantitative easing is stimulative. Together, they are extremely stimulative.

What is the GDP multiplier of quantitative easing as currently implemented?

Nominal and target rates aren't relevant; market interest rates (real rates) are the calculus used in a profit-maximizers decision making.

they are relevant, because U.S. currency is equivalent to a bond with zero nominal interest rate (it does not pay any interest), not zero real interest rate.

 

[talk2glenn]

What is the GDP multiplier of quantitative easing as currently implemented?

I don't know. Is there any useful mechanism for tracking new currency injected as part of specific board actions? No. Does the Fed have techniques for reliably estimating the point? Yes, but I'm not aware of any published reports on the matter.

That said, the Federal Reserve estimates the current US money multiplier at less than 2.

This is not the same thing as GDP multiplier; some of that money goes to paying for price increases, and some of its goes to paying for production increases. Inflation is low, but still present.

they are relevant, because U.S. currency is equivalent to a bond with zero nominal interest rate (it does not pay any interest), not zero real interest rate.

No, it's not. Currency is not a bond, and bonds are not currency. They are two entirely succinct goods, and have value because they satisfy two independent wants.

 

[hamster143]

I don't know. Is there any useful mechanism for tracking new currency injected as part of specific board actions? No. Does the Fed have techniques for reliably estimating the point? Yes, but I'm not aware of any published reports on the matter.

That said, the Federal Reserve estimates the current US money multiplier at less than 2.

This is not the same thing as GDP multiplier; some of that money goes to paying for price increases, and some of its goes to paying for production increases. Inflation is low, but still present.

The only semi-credible source I could find that was willing to go on record on this subject, predicted gains of 0.5% of GDP, as a result of quantitative easing on the scale of 10% of GDP, giving the multiplier of 0.05

http://www.businessinsider.com/jan-hatzius-quantitative-easing-2-unemployment-2010-11

as compared to 0.5-2.5 to most types of deficit spending

http://economistsview.typepad.com/.a/6a00d83451b33869e20112791a2a1328a4-800wi

No, it's not. Currency is not a bond, and bonds are not currency. They are two entirely succinct goods, and have value because they satisfy two independent wants.

But the original point was that holding currency is functionally equivalent to holding short term bonds when the interest rate is zero.

This is true when the nominal interest rate is zero (or, at least, I can't see any practical differences between holding currency and holding bonds, even though they are different goods).

This is not true when the real interest rate is zero: assuming 2% inflation, riskless bonds pay 2% nominal, cash pays 0% nominal, and bonds are clearly preferable to cash.

 

[WhoWee]

I think the next logical questions are as follows:

1.) What will Bernanke's options be if inflation suddenly exceeds estimates before QE-2 is complete - possibly lead by the currently increasing oil prices?

2.) What is the primary indicator that will signal it's time to stop suppressing interest rates. Also, how would this be affected by an unexpected rise in inflation.

3.) How would a hard cap on the Federal debt limit - (assume it requires drastic spending cuts over the next 6 months) impact the interest rate over the next 12 months?

 

[talk2glenn]

The only semi-credible source I could find that was willing to go on record on this subject, predicted gains of 0.5% of GDP, as a result of quantitative easing on the scale of 10% of GDP, giving the multiplier of 0.05

Forgetting for a moment that I see no reason to regard Mr. Hatzius' comments as anything more than idle speculation, we need to correct your numbers a bit. The scale of QE2 is approximately 3.5% of U.S. GDP, and I believe this analyst was referring to a 0.5% initial boost in growth rates over the term (though the article is admittedly poorly written), and not trying to quantify net cumulative effects.

In the long run, the benefits to GDP growth will outlast the term of the Fed's program, due to the multiplier effect. You need to be more critical in your analysis.

But the original point was that holding currency is functionally equivalent to holding short term bonds when the interest rate is zero.

Alright, I see what you are saying. Yes, it is conceivable that there could be functional equivalence, as defined by return on investment. But cash is not an investment, and people typically do not hold it as a store of value (even in a money market account), but instead hold it to finance transactions and protect wealth. Even if the case of functional equivalence, people would not see cash as an investment, but as a protection against the risks of the (poorly performing) bond market.

In practice, this sort of environment would incentivize borrowing and provide a disincentive to lend, driving interest rates up quickly. Further, no lender would agree to loan money at a 0% rate of return, and no matter how high bond prices rose yields on positive-return bonds could never, mathematically, fall to 0. The bond market may approach but never reach 0, nominally.

Real rates - after adjusting for inflation, transaction costs, and market risk - can both fall to zero and invert, though.

This is not true when the real interest rate is zero: assuming 2% inflation, riskless bonds pay 2% nominal, cash pays 0% nominal, and bonds are clearly preferable to cash.

I think your misunderstanding the difference between real and nominal rates.

In your example, given 2% inflation, the real return on bonds is 0%, but the real "return" on cash is -2%. You are correct though - bonds here are preferable to cash.

Imagine instead an environment where the yield on bonds was 0% and the inflation rate was 0%. In this case, bonds and cash are functionally equivalent. Are bonds preferable to cash in a profit maximizers mind? No, in fact there's no profit incentive to lend. On the other hand, there is tremendous incentive to borrow. The loanable funds market would tend to zero.

 

[hamster143]

Forgetting for a moment that I see no reason to regard Mr. Hatzius' comments as anything more than idle speculation, we need to correct your numbers a bit. The scale of QE2 is approximately 3.5% of U.S. GDP, and I believe this analyst was referring to a 0.5% initial boost in growth rates over the term (though the article is admittedly poorly written), and not trying to quantify net cumulative effects.

I would've very much liked to quote a source from stlouisfed.org or newyorkfed.org, but none of them were willing to offer projections with regard to the impact on GDP. There was one article that quantified the impact on long term rates (at 38 to 82 basis points per $1.725 trillion of quantitative easing) and stopped at that.

The projected scale of QE2 is consistently quoted as at least $1 trilion (6.7% of GDP) and potentially $2 trillion (13.3% of GDP). I'm not sure where your 3.5% of GDP number comes from.

 

[WhoWee]

I think the next logical questions are as follows:

1.) What will Bernanke's options be if inflation suddenly exceeds estimates before QE-2 is complete - possibly lead by the currently increasing oil prices?

2.) What is the primary indicator that will signal it's time to stop suppressing interest rates. Also, how would this be affected by an unexpected rise in inflation.

3.) How would a hard cap on the Federal debt limit - (assume it requires drastic spending cuts over the next 6 months) impact the interest rate over the next 12 months?

The weekly jobs report showed claims were up and are above the 4 week average. The latest consumer price index is also +1.1%.

http://www.dol.gov/

"Latest NumbersConsumer Price Index (CPI)
+0.1% in November 2010
Unemployment Rate
9.4% in December 2010
Payroll Employment
+103,000(p) in December 2010
Average Hourly Earnings
+$0.03(p) in December 2010
Producer Price Index
+1.1%(p) in December 2010
Employment Cost Index
+0.4% in 3rd Qtr of 2010
Productivity
+2.3% in 3rd Qtr of 2010
U.S. Import Price Index
+1.1% in December 2010
Unemployment Initial (UI) Claims
445,000 in the week ending January 8, 2011
UI Claims 4-Week Average
416,500 in the week ending January 8, 2011
Federal Minimum Wage
$7.25 in Current"

my bold

 

[WhoWee]

Also:
http://online.wsj.com/article/BT-CO-20110113-704764.html

UPDATE: S&P, Moody's Warn On US Credit Rating Due To Rising Debt

 

[PhilKravitz]

inflation

Judging from your experience shopping what do you estimate the inflation rate to be? Does your experience indicate that a rate of zero as reported by the federal government is correct?

 

[WhoWee]

Judging from your experience shopping what do you estimate the inflation rate to be? Does your experience indicate that a rate of zero as reported by the federal government is correct?

It might be helpful to post a link to the information you've cited?

 

[PhilKravitz]

?? I have not cited any information. I have asked a question about the life experience of the reads.

The zero is the COLA for social security this year.
see federal government web page http://www.ssa.gov/cola/

 

[WhoWee]

?? I have not cited any information. I have asked a question about the life experience of the reads.

The zero is the COLA for social security this year.
see federal government web page http://www.ssa.gov/cola/

I'm sorry, that was not clear.

 

[WhoWee]

I don't know.

However, this chart (Commodity Price Index) might give us an idea of what is headed our way. In Dec 2010, we climbed back to February 2008 levels - with a continued upward trend including oil and corn prices.

http://www.indexmundi.com/commodities/?commodity=commodity-price-index&months=300

The Commodity Food Price Index is very near the 20 year high.
http://www.indexmundi.com/commodities/?commodity=food-price-index&months=240

The Crude Oil (petroleum) Price index (aside from the Summer 08 spike) seems to be on a very steady upward trend that began in 1999.
http://www.indexmundi.com/commodities/?commodity=petroleum-price-index&months=240

Perhaps the most telling trend is the Commodity Agricultural Raw Materials Index. We are at a 30 year high.

http://www.indexmundi.com/commodities/?commodity=agricultural-raw-materials-price-index&months=240