The questions are:
Why do you think inflation has been low in US after the 2008 recession? (this post)
What is the most important thing economists get wrong about the way banks work?
What are your thoughts on NGDP targeting?
What are your thoughts on free banking?
I'll provide links in each post to the other 3 as they come out.
FH: Why do you think inflation has been low in the US after the 2008 recession?
JN: First, it depends what we mean by inflation. If we simply mean ‘CPI inflation’, then the reasons aren’t fully clear. The ability of the banking system to expand lending has been multiplied by the large amounts of reserves injected into the system through the various QE programmes. Excess reserves have jumped and the money multiplier has collapsed, indicating that banks haven’t increased lending volume much. However, it is a mistake to believe that inflation would sky-rocket within years of this massive liquidity injection by the Fed. The crisis involved a balance sheet-led recession, meaning that many banks and bank customers were insolvent. In such case, people and companies attempt to clean up their balance sheet before borrowing again. The experience of the Great Depression clearly showed that it can take decades for the money multiplier to get back to its previous highs.
Moreover, the Fed started paying interest on excess reserves. Bankers started facing two options: 1. lend to customers at low interest rates, which involves risk premiums (liquidity and credit risk) and convert some of the excess reserves into required reserves and 2. do not lend and keep this risk-free money where it is, at even lower yields. It looks like, at least for several years after the onset of the crisis, that the risk-adjusted option 1 was often less remunerative than option 2, in particular if we add the operating and capital cost of inter-mediation to option 1. With such low nominal interest rates, banks were already facing the phenomenon of ‘margin compression’ (rates paid on loans were falling while rates paid on deposits couldn’t fall any further), which made it more difficult to cover operating costs.
Another reason for the slow lending growth is banking regulation and litigation. Banks have been hammered with thousands of pages of new rules since the crisis, despite suffering from mass customer defaults and heavy fair value losses on their financial instruments and paying out huge fines to US and international regulatory agencies. The consequence being that the transmission mechanism of monetary policy was half-broken (‘half’ because QE still seemed to have some positive effects by boosting asset values).
Now that most banks have rebuilt their balance sheets and reinforced their capitalization levels, we are likely to start witnessing lending growth again. Over the past 18 months, excess reserves have been on a slight (but highly fluctuating) downward path and US banks’ total assets and lending volume have been increasing again.
Apart from the banking system, we need to keep in mind that the growth of emerging markets, in particular China, has had an exogenous effect on CPI figures by keeping costs down. Within the US, there might also be extra non-banking related economic reasons, such as productivity growth that would ‘hide’ inflationary pressure (some economists even suggest that the rise of the internet/IT industry means that we are mis-understating productivity and GDP growth).
Finally, we could also consider ‘inflation’ not included in the CPI. Asset prices have boomed over the past few years. Equity markets have jumped to new record highs despite a relatively slow economic recovery. Fixed income markets have witnessed a hunt for yield as yields on a number of risky assets have fallen to very low levels due to high investor demand. Since 2013, housing prices have also started to increase again and some banks reported very high mortgage lending volume growth (which then slowed down). As money keeps being recycled in asset purchases, it doesn’t enter into the calculation of the CPI.
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