On the Relation of the Dollar, Inflation, and Asset Prices

     Steve Heinke has an interesting piece in the Business Insider about the relationship between the dollar and inflation. Hat Tip (HT) to Woj as I saw the link for this piece on his Twitter page. The title of Heinke's piece is actually "No, Hyperinflation is Not Coming to the U.S."

      It's welcome to hear someone in the business press get it right as we have heard a lot of urban legends about the threat of hyperinflation any day now. He explains that hyperinflation is a very rare occurrence that appears only in very extreme situations:

     "Hyperinflation arises only under the most extreme conditions, such as war, political mismanagement, or the transition from a command economy to a market-based economy. If you compare the U.S. to countries that have experienced hyperinflation– think Iran, North Korea, Zimbabwe, and the former Yugoslavia, for example — the U.S. doesn’t even come close. Hyperinflation begins when a country experiences an inflation rate of greater than 50% percent per month — which comes out to about 13,000% per year. Although it experienced elevated inflation around the time of the Revolution and the Civil War, the United States has never passed this magic mark. At present, the U.S. inflation rate, measured by the consumer price index (CPI), is less than 2% per year. So, to say that the U.S. is on its way to hyperinflation is just nonsense."

    Read more: http://www.businessinsider.com/hyperinflation-no-inflation-yes-2013-3#ixzz2PDezR6f6    

    Another point that's been made by the MMTers  is that hyperinflation doesn't come as a result of wildly printing money but rather the money printing usually follows hyperinflation. Essentially unless some pretty extreme conditions like war, etc. are present-Germany's Weimar Republic had a need to pay off it's huge war debt-hyperinflation is just a fantasy. 

    While this point was also the title of the piece, Heinke then gets into some other interesting points. He points out something the MMTers also point out a lot with regard to why QE hasn't led us to skyrocketing inflation-even if hyperinflation is in the cards you might expect high and rising inflation to result. 

     Heinke makes the point that the Fed can only impact a small part of the money supply. The Fed controls just 15% of the money supply while private banks control 85%:

     "What many people fail to understand is that the money created by the Fed, through programs like Quantitative Easing, is what’s known as “state money” (monetary base). In the U.S., this makes up only 15% of the money supply, broadly measured. The remainder is made up of “bank money” — the all important portion of the money supply produced by banks, through deposit creation."

      "So, while the Fed has more than tripled the supply of state money since the collapse of Lehman Brothers, in September 2008, this component of the money supply is still paltry compared to the total money supply. In fact, when measured broadly, using a Divisia M4 metric, the U.S. money supply is actually 6% below trend."

      He then goes on to argue something I'm skeptical of: that one thing that's holding back bank money is Dodd-Frank and Basel III:

      "There are a number of factors that affect the growth of money, but there are two main factors that have hampered broad money growth in the United States since the financial crisis. Not surprisingly, they are both government created. The first is the squeeze that has been put on the banks, as a result of Dodd-Frank and Basel III capital-asset ratio hikes. By requiring banks to hold more capital per dollar of assets (read: loans), the regulators have put a constraint on bank’s balance sheets, which limits their ability to lend. In consequence, money supply growth has been slower than it would have otherwise been."

      He then makes a very counteintuitive argument about low interest rates which I don't know that I totally even understand. 

      "The other factor is the credit crunch created by the Fed’s zero-interest-rate policy. This has dried up the interbank lending market, because banks have little financial incentive to lend to each other. Without a well-functioning interbank lending market to ensure balance sheet liquidity, banks have been unwilling to scale up or even retain their forward loan commitments"

      "The end result is a loose state money/tight bank money monetary mix. And since bank money makes up 85% of the total, the money supply in the U.S. is still, on balance, tight and below trend. That said, the broad Divisia M4 measure of the money supply has started to show signs of life in recent months."

       This is totally the opposite of what's supposed to happen when you have low interest rates. He argues that they represent "loose money" for the state money slice of the money supply but "tight money" for the bank money part. Again, I don't entirely know what to make of this argument. Anyone have any thoughts?

       Finally we come to the subject of the title of my post. He makes some very interesting observations about correlations regarding the dollar with respect to inflation and asset prices-stocks, commodities, housing prices. I don't know that I buy all of his conclusions but it makes you think:

       He claims to avoid inflation going forward the Fed should pay attention to the dollar-mind you, he has already explained that QE is not inflationary, as it only impacts state money, so why should we expect elevated inflation going forward?

      "The Fed should start paying attention to the dollar. While operating under a regime of inflation targeting and a floating U.S. dollar exchange rate, Chairman Bernanke has seen fit to ignore fluctuations in the value of the dollar. Indeed, changes in the dollar’s exchange value do not appear as one of the six metrics on “Bernanke’s Dashboard” — the one the chairman uses to gauge the appropriateness of monetary policy. Perhaps this explains why Bernanke has been dismissive of questions suggesting that changes in the dollar’s exchange value influence either commodity prices or more broad gauges of inflation.

       "The relationship between the dollar’s value and inflation has been abundantly clear for the last decade. As Nobelist Robert Mundell has convincingly argued, changes in exchange rates transmit inflation (or deflation) into economies, and they can do so rapidly. This relationship was particularly pronounced during the financial crisis

        Mundell, however, was analyzing the old fixed rate Bretton Woods regime and I'm not sure how much his analysis is apples to apples for today. There has also been some debate over Mundell's model itself. 

        http://mainlymacro.blogspot.com/2013/03/why-we-should-stop-teaching-mundell.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+MainlyMacro+%28mainly+macro%29

        Nevertheless, Heinke is no doubt right regarding correlations we have seen in recent years regarding the dollar and specifically the dollar's exchange rate with the euro:

        "Indeed, from 2007-09, the monthly year-over-year percent changes in the consumer price index and in the USD/EUR exchange rate have a correlation of 0.75. As can be seen in the chart, there is a roughly two-month lag between changes in the USD/EUR exchange rate and in the CPI; when we factor in this lag, the correlation strengthens to 0.94."

        "By ignoring this, Bernanke was “flying blind” in the initial months of the crisis. In consequence, the Fed failed to stabilize the USD/EUR exchange rate, which swung dramatically in the months surrounding the collapse of Lehman Brothers."

        "Accordingly, the Fed acted too slowly in cutting the federal funds rate to stabilize inflation, which swung from an alarming rate of over 5% (year-over-year), to a negative (deflationary) rate in a matter of a few short months. If Bernanke had been monitoring the USD/EUR exchange rate, he would have realized that he was engaging in an ultra-tight monetary policy in the early months of the financial crisis. He would have known then to act much sooner than December 2008 — almost two months after the Lehman bankruptcy. Perhaps if he had tried to stabilize the value of the greenback, the bankruptcy may never have occurred in the first place."

        There has been without question, an impressive correlation between the dollar and commodity prices in recent years:

       "One important way the dollar’s value affects inflation is through commodity prices. With few exceptions, when the dollar weakens against the euro, commodity prices soar, and when the dollar soars against the euro, commodity prices plunge. As every commodity trader knows, when the value of the dollar falls, the nominal dollar prices of internationally traded commodities — like gold, rice, corn and oil — must increase because more dollars are required to purchase the same quantity of any commodity

       "During the 2002–July 2008 period, the dollar declined steeply against the euro, and commodity prices surged. When the dollar subsequently rebounded, after Lehman Brothers collapsed, commodity prices tumbled. And again, following the first quarter of 2009, the renewed decline in the dollar’s exchange rate brought with it another surge in commodity prices."

       "We can see the consequences of this relationship in the lead-up to the 2008 financial crisis. During the five years preceding the Lehman Brothers’ collapse, the Fed’s favorite inflation target — the consumer price index, absent food and energy prices — was increasing at a regular, modest rate. But, this was an illusion. As can be seen in the accompanying chart, a weakening dollar drove up asset prices in the equities, commodities, and, of course, housing markets."

       "Unbeknownst to the Fed, abrupt shifts in major relative prices were underfoot. For example, housing prices — measured by the Case-Shiller home price index — were surging, increasing by 45% from the first quarter in 2003 until their peak in the first quarter of 2006. Share prices were also on a tear, increasing by 66% from the first quarter of 2003 until they peaked in the first quarter of 2008."

       "The most dramatic price increases were in the commodities, however. Measured by the Commodity Research Bureau’s spot index, commodity prices increased by 92% from the first quarter of 2003 to their pre-Lehman Brothers peak in the second quarter of 2008."

       "The dramatic jump in commodity prices was due, in large part, to the fact that a weak dollar accompanied the Fed’s ultra-low interest rates. Measured by the Federal Reserve’s Trade-Weighted Exchange Index for major currencies, the greenback fell in value by 30.5% from 2003 to mid-July 2008."

       "For any economist worth his salt, these relative price changes should have set off alarm bells. Unfortunately, the Fed’s CPI inflation metric signaled “no problems”.

     

       "No doubt, this is something traders have been aware of for a long time: when the dollar gets weak commodity prices rise and vice versa. Actually stocks have behaved the same way and generally the economy has gone up with asset prices while the dollar has sunk and vice versa. This relationship wasn't present in the 80s and 90s when equities soared while commodities like oil had a 20 year bear market. So attempting to strengthen the dollar would have a tendency to weaken the economy based on recent history-the last 10 years."

      "I'm also not sure of his proposal to fix what he sees as a problem: he seems to favor something on the line of a kind of informal fixed exchange rate with the euro

     "When it comes to exchange rates, stability might not be everything, but everything is nothing without stability. The world’s two most important currencies — the dollar and the euro — should, via formal agreement, trade in a zone ($1.20 - $1.40 to the euro, for example). The European Central Bank would be obliged to maintain this zone of stability by defending a weak dollar (by purchasing dollars). Likewise, the Fed would be obliged to defend a weak euro (by purchasing euros)."

      Seems to me that this bottom on the dollar would effectively mean a cap on growth. I don't know that he's not overestimating the importance of stability in this particular exchange rate. He mentioned that the dollar has been rising recently-partly due one would think because of the weakness of EU growth bringing down the euro. 

       Nevertheless this overall piece was thought provoking while he may be wrong on some things.