Monday, January 18, 2010
Yet, despite having the two classic ingredients for high inflation, the United States has experienced only benign price increases. Over the last year, the core Consumer Price Index, excluding food and energy, has risen by less than 2 percent. And long-term interest rates remain relatively low, suggesting that the bond market isn�t terribly worried about inflation. What gives?Indeed they are not. Mankiw points out two: quantitative easing and interest paid on reserves. He does not note that excess reserves may be encouraged by the payment of interest. Moreover, as John Mauldin writes in his weekly analysis, we know that the quantitative easing will end soon:
Part of the answer is that while we have large budget deficits and rapid money growth, one isn�t causing the other. Ben S. Bernanke, the Fed chairman, has been printing money not to finance President Obama�s spending but to rescue the financial system and prop up a weak economy.
Moreover, banks have been happy to hold much of that new money as excess reserves. In normal times when the Fed expands the monetary base, banks lend that money, and other money-supply measures grow in parallel. But these are not normal times.
The Federal Reserve has been very clear about the fact that they intend to stop the quantitative easing program at the end of March. What that means in practice is that they are going to stop buying mortgage securities. That does two things. As Bill Gross so aptly points out, those mortgage purchases helped keep mortgage rates low. But they also financed the US government fiscal deficit, albeit indirectly. It seems that funds and banks that sold the mortgage securities turned around and bought US government debt or put the cash right back at the Fed.The quantity of Treasuries bought has to equal the quantity of Treasuries sold. If you can't sell them at current interest rates, don't they have to go up? Mankiw wonders too:
Foreigners bought about $300 billion of the $1.5 trillion in new government debt. The rest came from the US, courtesy of the Fed buying mortgages. But that program stops (theoretically) at the end of March. The government still plans to run yet another $1.4-trillion-dollar deficit (give or take a few hundred billion). The question is, who will buy the debt? Foreigners will kick in another $300 billion, unless they decide to stop selling us stuff, or buy other less liquid or physical assets. So far there is no sign of that.
But as I asked last year, who is going to buy the multiple trillions in government debt that the G-7 countries want to issue? Who is going to buy another $1 trillion here in just the US? That is 7% of GDP. That means that consumers and businesses will have to save an additional 7% of GDP just to finance government debt at the federal level, not counting state and local debt.
Investors snapping up 30-year Treasury bonds paying less than 5 percent are betting that the Fed will keep these inflation risks in check. They are probably right. But because current monetary and fiscal policy is so far outside the bounds of historical norms, it�s hard for anyone to be sure. A decade from now, we may look back at today�s bond market as the irrational exuberance of this era.One can only imagine what this does for investment and housing.