QUESTIONS ABOUT THE FLEXIBILITY OF FUTURE MONETARY POLICY IN THE US AND THE UK

We now know that the Federal Open Market Committee (FOMC) of the Federal Reserve Bank has decided to accelerate its tapering program, so that it will buy less US Treasury debt with longer terms to maturity and fewer non-Treasury securities.  But we also now know that the FOMC does not plan to begin tightening monetary policy explicitly until next year.  This is in contrast to the Bank of England, which CNBC announced has increased its target for the inter-bank lending rate.

I have not been monitoring economic data or conditions in the United Kingdom much.  Perhaps this makes me wonder what could have led these two central banks to reach different decisions.  

Focusing on the US, did the FOMC think about the disappointing report for US retail sales from the US Census Bureau for November 2021 (announced by CNBC and others) which showed relatively modest growth when compared with October 2021?  Realizing that US retail sales are reported in nominal terms (not adjusted for inflation), is it possible that in real terms, US real retail sales fell in November 2021 when compared with October 2021?  A decline in real retail sales would imply that people in the US actually bought fewer goods and services in October 2021 than the month before.  To what extent does the possibility raised by CNBC's Steve Liesman that US consumers accelerated holiday spending into October of 2021 apply so that US consumption remains strong?  If I heard Carl Quintanilla of CNBC correctly today, then is US consumption softening?  If so, then I wonder is part of that softening due to people running out of stimulus funds?

Are the velocities of the US M1 and M2 money supplies still falling in the fourth quarter of this year?  If so, then does that help to explain relatively weak November 2021 US retail sales and the FOMC's decision?  My book It's Velocity, Stupid! has more information about money velocity in the US.

Are the FOMC and US consumers and others concerned about COVID-19 coronavirus developments?  Will people be concerned about resuming or continuing to resume normal activities?

The FOMC (and almost certainly the Bank of England) had been considering raising interest rate targets to control inflation pressure.  Recently, if I heard correctly, then frequent CNBC network guest Josh Brown said on that network that US inflation expectations over a certain duration were below three per cent.  Does this suggest that the FOMC does not need to tighten much, if at all, at least presently?  As I pointed out in previous blog posts (with links below), US Treasury interest rates are pretty low, perhaps reinforcing the view that expected inflation may not have risen very much.

https://harrisonhartman.blogspot.com/2021/12/does-money-velocity-tell-us-anything.html

https://harrisonhartman.blogspot.com/2021/12/interest-rates-expected-inflation-and.html

 

Compared with the US, are conditions very different in the United Kingdom?  If not, then does the FOMC have a stronger preference than the Bank of England for flexibility in future monetary policy decisions?  

If economic conditions are fairly similar if not very similar in the UK and the US, then was it better to start raising interest rate targets in the year 2021?  Or is it better to prepare the market for the possibility, if not the likelihood of higher interest rates next year but allow perhaps more flexibility to continue with easier monetary policy if conditions warrant such policy?  The latter strategy comes with the disadvantage of perhaps continuing to fuel inflation pressure and possibly reducing inflation-fighting credibility.  

However, as implied above, the advantage of the latter approach is that if either economic growth slows substantially for any reason, or if a problem arises in financial markets, or if inflation winds up having been essentially under control, (or a combination of two or all three of those possibilities occurs); then the latter strategy enables the central bank to continue expansionary policy with perhaps less of the appearance of reversing course.  That is to say that, in a sense, monetary policy could remain more data determined in the face of potentially great uncertainty.  And although not explicitly tightening yet but by tapering faster, the Fed injects less liquidity into the economy than it otherwise would without tapering faster, thus helping to reduce inflation pressure.

My forthcoming book will probably have more information about why the US  (and likely other countries) may want to pursue expansionary policy, and perhaps particularly expansionary fiscal  policy.  But, returning focus to monetary policy decisions, we will need to see what happens in the future to assess more completely which policy decision was better.

DOES MONEY VELOCITY TELL US ANYTHING ABOUT INFLATION AND THE NEED TO TIGHTEN?

As we prepare for an announcement soon about the future course of monetary policy in the United States, some comments about money velocity and inflation may be useful.  If I heard correctly, then Steve Liesman of CNBC television reported yesterday (Monday) morning that more than forty per cent of survey respondents think that the Federal Open Market Committee (FOMC) of the Federal Reserve Bank may not only taper more (meaning further slow down the Fed's purchases of U.S. Treasury longer-term debt) soon, but the FOMC may also pursue tighter monetary policy, by raising the target for the federal funds rate, or the bank-to-bank overnight lending rate.  The Fed would change its purchases and/or sales of U.S. Treasury T-bills with a short term to maturity as needed to achieve its goal for the federal funds rate.  A monetary policy tightening would result in less aggregate demand in the economy, all other things  equal.  If the FOMC reduces the level of aggregate demand or at least the growth rate of aggregate demand if not the level of aggregate demand, then prices would not rise as quickly.

Presently, is it necessary for the Fed to tighten?  While others may not agree, at least in my view, the answer to the question is unclear.  The M1 and M2 money supply levels have increased quite rapidly since the start of the Great Recession, and even more rapidly since the start of the COVID-19-related economic collapse.  With unemployment rates in the U.S. now relatively low and real GDP having resumed growth, it is understandable that people are concerned about controlling inflation pressure as inflation has increased while (a) aggregate demand growth has increased and (b) supply-side issues are helping to increase costs.

However, as I pointed out in my previous blog entry (https://harrisonhartman.blogspot.com/2021/12/interest-rates-expected-inflation-and.html), financial markets may be signaling only a relatively modest increase in expected inflation.  Further, frequent CNBC guest Art Cashin may point out that the velocities of both the M1 and M2 money supply levels in the U.S. may still be falling (although he might emphasize M2 velocity).  In his view, that could indicate little pressure for inflation.  I think he said on CNBC more than once in the past that spending and lending lead to inflation, but simply holding money does not.  (My memory is that my book It's Velocity, Stupid! (short title) also questioned whether inflation would rise without an increase in money velocity.)  Clearly, an increase in spending could increase inflation, the percentage growth rate of the price level, or at least lead to a one time  increase in the price level.  Greater spending all other things equal results in an increase in aggregate demand.  In a simple aggregate supply/aggregate demand (AS/AD) framework, the equilibrium price variable is higher when the AD function shifts right.  A possible topic for future discussion and/or research could be whether an increase in loans granted without an increase in spending leads to inflation.

I do not know if Art Cashin still feels the same as he did about money velocity and inflation.  Regardless, if his previous if not current analysis about money velocity is accurate, then the FOMC would risk spurring a nearly pointless if not completely pointless recession by shifting the AD function left by tightening without a level of inflation pressure that many would think would warrant such a policy shift so soon.  If I heard frequent CNBC guest Josh Brown today (Tuesday) on that network correctly, he thinks that inflation in the U.S. is at its (local) peak now.  If that turns out to be correct, then there may be little or no need for tightening at the present.  More about the possible need for continued expansionary fiscal policy in the U.S. (and likely also other countries) will probably be in my forthcoming book.  We will probably get another glimpse at the FOMC plans starting tomorrow.

(Added December 17, 2021:  Tapering by the Federal Reserve Bank could also include the Fed buying fewer non-Treasury securities.)

INTEREST RATES, EXPECTED INFLATION, AND A POSSIBLE BENEFIT OF FISCAL POLICY OVER MONETARY POLICY

Given that United States inflation rates have risen from what may have been a briefly negative rate during at least part of the COVID-19-related economic collapse to positive rates that are now likely greater than rates during perhaps all of the Not-So-Great Recovery (based on implicit deflator data from the FRED website of the Saint Louis Federal Reserve Bank accessed December 6, 2021), it may not be surprising that at least some are calling for the Federal Open Market Committee of the Federal Reserve Bank to tighten monetary policy. Inflation expectations may be a factor, as market participants may expect an increase in the rate of inflation, in part due to very expansionary monetary policy in recent years. Perhaps an increase in expected inflation winds up being reflected in actual inflation rates, all other things equal. 

What do bond market participants expect inflation rates will be in the U.S. in coming years? In a textbook-style approach, thinking attributed to Irving Fisher states that the nominal interest rate paid by bonds equals the sum of a real interest rate that lenders (and perhaps also borrowers) try to maintain plus an inflation premium. The inflation premium varies with expected inflation. At least one complicating factor appears a few paragraphs below. 

But for now, consider an illustrative example. Let’s suppose that lenders attempt to keep a three per cent real return per year for lending their funds. A three per cent real interest rate (or real return) means that because lenders granted loans, they would be able to increase their buying power on average (as some goods would have prices rising but other goods would have no price increase and some could have a price decrease) by three per cent per year when they are repaid with principal and interest. If lenders expect that inflation will be two per cent per year over the life of a loan, then they could require a five per cent nominal interest rate. Subtracting an expected inflation rate of two per cent per year from the five per cent nominal interest rate would give lenders a three per cent real interest rate if the inflation expectation turned out to be accurate. 

Readers should note that nominal interest rates are measured in either U.S. dollars or units of other currencies that are not measured in constant buying power. Of course, the buying power of currency changes as prices change, and when most prices in the economy tend to rise, the buying power of each unit of currency tends to fall because each unit of currency on average can buy fewer goods and services than before the price increase. Real interest rates are measured in units of currencies that have constant buying power. 

If lenders expect that inflation rates will be higher than before, for example seven per cent, then to preserve the three per cent real interest rate, lenders could require a ten per cent nominal interest rate – the three per cent targeted real return plus a seven per cent inflation premium. If borrowers also think that inflation will be higher, then they are more likely to be willing to pay the higher nominal interest rate of ten per cent because they would be repaying the loan in dollars or other currencies that have less buying power. This reasoning helps to explain how an increase in inflation expectations can result in higher nominal interest rates on loans. 

Given that many if not most (or all) interest rates in the U.S. economy have risen, one explanation for these increases would be an increase in inflation expectations. However, in light of the facts that (1) interest rates on U.S. Treasury notes maturing in ten years and U.S. Treasury bonds maturing in thirty years are still relatively low (both less than two per cent as of this writing as shown on CNBC television on December 6, 2021) compared with interest rates at least over the past few decades if not longer, and (2) most if not all interest rates probably rose by much less than two percentage points (because the ten year and thirty years rates almost certainly did not go negative), have inflation expectations risen all that much? Additionally, some approaching the term structure of interest rates from the perspective of the segmented markets hypothesis might explain the increase in interest rates on longer term U.S. Treasuries based on a change in the supply of U.S. Treasuries or a change in the demand for U.S. Treasuries or changes in both the supply of and the demand for U.S. securities, perhaps with little or no change in expected inflation. Still, a change in expected inflation could help to explain changes in the demands for and supplies of debt instruments. 

The above analysis may possibly provide some insight for policymakers and financial market participants. The Federal Reserve may not need to reduce its debt purchases as quickly as some think is necessary. Given that U.S. Treasury interest rates are not rising very rapidly now, to the extent that the analysis of Irving Fisher explains the recent increase of nominal interest rates on U.S. Treasuries, financial market participants may believe that U.S. inflation pressure is largely if not completely contained at the present. 

A possible complicating factor is that expansionary monetary policy may have a different effect on interest rates over different time horizons. Given the recent experience in the United States, expansionary monetary policy may cause interest rates to decrease, at least initially. The thinking is that as the money supply rises, at least part of the increase in the money supply winds up contributing to bank reserves, so that the federal funds rate decreases, all other things equal, because banks seeking short term loans will not need to offer to pay as much in interest to borrow the funds with more reserves in the system. Longer term rates could possibly also fall due to a greater money supply and due to potential substitutability between debt with differing maturity lengths. However, over time, continued expansionary monetary policy could cause interest rates to rise, as lenders expect higher inflation in the future. This suggests that the role of monetary policy could dominate inflation expectations in the short term regarding nominal interest rates on debt instruments. In turn, it may be essential to conduct surveys to determine expected inflation in an economy because market participants may not be able to override the impact of monetary policy on interest rates, particularly in the short term. 

Related to the above about the possible difference between the short term impact versus the long term impact of monetary policy on interest rates, the current situation in the U.S. regarding monetary policy, inflation rates, and nominal interest rates on U.S. Treasury debt provides evidence that it may take quite a while for expansionary policy to result in a roughly proportional increase in the price level, the percentage increase in the latter being a measure of the inflation rate. Large percentage increases in the money supply at least some times have been accompanied by decreases in the velocity of money so that total spending on the items in gross domestic product (GDP) measured in nominal terms has not increased by a percentage as large as the increase in the money supply. My book It’s Velocity, Stupid! (short title) has more information on the plunge in the velocity of the M1 measure of the money supply in the U.S. that started in the first quarter of the year 2008. 

Readers may realize that the Fed in the U.S. has a dual mandate to pursue policies that (1) contain inflation and (2) increase employment. A potential problem for the Fed is that policies that reduce inflation such as raising interest rate targets and reducing the money supply growth rate could result in reducing real GDP growth (possibly to the point of economic recession or negative growth) and reducing employment. Despite this, the Fed may need to implement tighter monetary policy to prevent inflation from surging to levels that many would find unacceptable. 

However, could interest rates in the U.S. Treasury debt market indicate that the Fed does not need to tighten by much in the short term? Could it be that the market for U.S. Treasuries indicates that additional expansionary monetary policy for a bit longer than the Fed’s current plans would not increase inflation rates by much? If the Fed pursues more contractionary policy, then expansionary fiscal policy (reductions in taxes, increases in government spending) could help to continue to stimulate economic growth. Further, strategic expansionary fiscal policy may spark less inflation pressure than additional expansionary monetary policy. I may have more about this and at least some of the other topics in this blog entry in my upcoming book (hint hint 😉). It could be interesting and informative reading. 

Of course, all other things equal, expansionary fiscal policy means budget deficits.  But, from a modern money theory perspective such as in Stephanie Kelton’s The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy (2020 [first release], Public Affairs), my understanding of the concern of additional expansionary fiscal policy would be how to find and assign resources into the production of goods and services. By contrast, from a non-modern money theory perspective, the interest cost of the debt used to finance the federal deficit spending is still quite low. 

Readers may want to note a difference between tapering and tightening in monetary policy. Tapering in this context refers to the Fed buying fewer longer-term assets. For example, the Fed used tapering to phase out its quantitative easing measures implemented in response to the Great Recession. By contrast, tightening by the Fed would imply the Fed increasing its target for the federal funds rate, the bank-to-bank overnight interest rate. The Fed would cut back on buying short-term Treasury debt from depository institutions such as banks so that fewer reserves would be in the banking system, in turn creating pressure for the federal funds rate to rise. At this point, we may not need to emphasize the difference between tapering by the Fed and tightening by the Fed, except to note that the Fed may be more likely at this point to taper than to tighten.