personal views of a former fed trader

Mechanics of a Devaluation

The inflationary process is in its early stages, and it will be particularly strong because it arises in part from a devaluation of the world’s reserve currency. Governments throughout the world printed and spent trillions in their pandemic related efforts, but none of their actions came close to the American response. American households literally received trillions in newly printed money that they are just beginning to spend. Inflation will become more obvious as that money moves through constrained supply chains and the global dollar system. Most foreign countries tether their currency to the dollar, effectively forcing them to at least partially import inflationary U.S. policies. In this post we follow the free money as it makes its way through the domestic and global economy, explain why reserve currency devaluation is particularly inflationary, and suggest prices have further to rise.

From Printer to People

The U.S. took full advantage of its reserve currency status and deployed a pandemic response that was exceptional in its scale and form. Trillions were spent, with notable cash infusions that include $1.6t in direct payments to individuals and $1.1t in forgivable in “loans” to small businesses. The total fiscal response amounted to 25% of GDP, while the average response among other advanced economies was only 12%. Note that weaker sovereigns do not have the ability to deploy this level of “helicopter money.” Emerging markets and low income developing countries only mounted a very modest fiscal response.

Exorbitant privilege in action

The fiscal response was completely financed by money creation, which devalues the currency. Recall that QE changes the form of dollars, but it is deficit spending that actually creates dollars. From the perspective of non-banks, QE merely swaps Treasuries for bank deposits. But the issuance of a Treasury security creates out of thin air what are essentially dollar bills that pay interest. In practice, Treasury debt will never be repaid and just rolled over perpetually. When Treasury and Fed act in concert, then fiscal spending results in the issuance of new bank deposits out of thin air.

Households have $2t more freshly printed money in their checking accounts

In a prior post we reviewed the distribution of the new money by bank account size, but we can also splice the distribution by entity type. Here we see a $2t surge of checkable deposits held by U.S. households (as opposed to businesses or government entities etc.) This is an enormous increase in purchasing power, and it looks like there is a lot left.

From Households to Businesses

American households are living up to their reputation as big consumers and spending the money they received. Real consumer spending is above pre-pandemic levels, largely driven by a significant increase in spending on goods. This is likely in part because pandemic restrictions limited access to services. If restrictions are one day fully lifted then spending on services should also easily surpass pre-pandemic levels. The increased consumer spending can also be seen in surging corporate profits, which mirror the increase in household cash holdings.

Demand is above pre-pandemic levels driven by a boom in goods purchases
Free money is flowing to the corporates as profits when households make purchases

From Households to Global

Increased U.S. demand flows through interconnected supply chains, so higher U.S. consumer spending also impacts economic conditions abroad. This can be seen in a widening U.S. trade deficit, which is at historic lows. From a foreign country perspective, increased export demand results in inflationary pressures which can be moderated by allowing their home currency to appreciate. But that policy tool is limited when the increased demand arises from more dollars.

Free money flows abroad as households purchases arrive through global supply chains

The world runs on a dollar standard much like it once ran on a gold standard. Most of the trade in the world is invoiced in dollars, and most FX trades are against the USD. The dollar exchange rate impacts a foreign country’s trade competitiveness, and the solvency of its corporations. This means many foreign countries manage their currency by softly pegging it to the dollar as if it were gold. The impact of an influx of dollars under a dollar standard is like the discovery of a new gold mine under the gold standard: globally inflationary. This is part of the reason why some emerging markets have already started hiking rates.

Source: Bloomberg article “Central Banks Turning Slowly in Ending Pandemic’s Easy Money Era” by Enda Curran.

Rising Expectations

The inflationary impact of a currency devaluation arises from real transactions but also from expectations. When the Roosevelt Administration devalued the dollar it was very open with its intent to inflate prices. The public responded accordingly and rushed out to make purchases today in fear of higher prices tomorrow. This time around the policies are also obviously inflationary, but the accompanying messaging downplays inflation. Note that official sector communication is a policy tool used to influence expectations, and not necessarily a statement of belief.

Soothing words from officials and their friends can help tamp down on inflation, but only temporarily. The current context is tremendously inflationary. Households gained trillions in cash, their assets values are all time highs, and they feel confident enough to quit their jobs at record rates. They are very likely to keep spending (lots of) money. Supply chain constraints are also real, as are rising energy costs. Should the public begin to realize that it makes sense to buy today rather than tomorrow, then inflation could really skyrocket.

Inflation expectations are rising. Source: FRBNY

51 Comments

  1. Effem

    This seems quite obvious. Does the Fed understand this? If not, why not?

    • jeff

      does Jeff Snider, David Rosenberg, Steven van metre, or any of the other delusional deflationists understand this?

      • Effem

        No. Luckily they are not in charge of monetary policy. The Fed is, however, and if they don’t understand this dynamic that is quite surprising and alarming.

      • Emil Kalinowski

        Hey hey hey, if anyone is going to be called delusional it’s me. I don’t mind being cared deflationist, inflationist or left-handed but to be left out of your delusional list… it’s just surprising is all.

        • Vozmo

          Unfortunately your affinity for the yellow metal that shall not be named disqualifies you for inclusion on the list.

        • T

          Hey Emil
          Big fan of your channel!
          Loved that you found out about this blog.

        • Arman Arbab

          Hey hey, nice to see you here

      • Thomas

        Need to add Lacy Hunt to the list too.

    • Wankel YU

      Powell did not earn enough for himself yet,

  2. Dave Purnell

    Hi Joseph, thanks for your posts, which I read every week.
    re. “the issuance of a Treasury security creates out of thin air what are essentially dollar bills that pay interest”.
    To me this sounds like a money printer, which I don’t think is what you meant (please correct me if I am wrong). Is it more that the Treasuries are paid for with dollars investors have already ‘saved’, which don’t cause inflation, but which are then converted into inflationary dollars via government spending?

    • Joseph Wang

      Yes deficit spending is like printing money because Treasuries are a form of money.

      If you have money in a bank and you use it to purchase Treasuries, you are essentially swapping one form of money with another. It is the creation of new money that is inflationary, rather than changing the form. Similarly, if you have Treasuries you can easily just sell them for bank deposits that you can use to purchase goods/services. That ease of convertibility between Treasuries/currency/bank deposits is part of what makes Treasuries a form of money.

      • Andy

        To double check, Treasuries are the new asset created correct? Initially deposits, but then (likely other) deposits (and reserve behind them) are swapped out and replaced with Treasuries. While take your point that TSY is another form of money, shouldn’t government deficits consequently have no net impact on M2?

        • Joseph Wang

          If there is no Fed involvement you are right. Person A exchanges 100 in bank deposits for 100 in Treasuries. Gov takes that money and gives it to Person B, who gains 100 in bank deposits. So bank deposits overall unchanged, but the allocation is different. (Also note that if the gov just lets money it borrowed sit in its checking account at Fed instead of spending it, M2 will decline).

      • Dave

        I do see Dave P’s point though, in that it is the creation of new money, but also where it is spent that is inflationary (if new money isn’t spent, it isn’t inflationary). Issuance of Treasuries to unlock cash savings which are re-directed by the Treasury into Main St should be inflationary for consumer prices. Issuance of Treasuries which are replaced by bank deposits by Fed’s QE and then spent by the cash pool on risk assets is inflationary for asset prices (along with a double whammy of Treasury redirection and consumer price inflation as in the first case).

  3. Henrique

    First, I want to say that I loved your book!
    Joseph, how does this fiscal policy led by the FED plays out with the Eurodollar economy and the demand for dollars to pay the dollar-denominated debt?

    • Joseph Wang

      Thanks! There are more dollars in the world as a result of policy actions, and they flow abroad through trade and investment. So it easier to pay off dollar denominated loans, both on-shore and off-shore. Loose US fiscal policy is actually very good for the global economy.

      • Effem

        I don’t understand how you conclude nominal policy has a real effect. It could, but need not. Isn’t money neutral? If North Korea were to counterfeit $10t and spend it would that be “very good for the global economy?”

        • Joseph Wang

          Because dollar debt is global and fixed in nominal terms, inflation reduces that and improves real net worth.

          • Effem

            Disagree. The owner of the debt suffers a loss in real net worth. Printing money has no real effect long-term or else it’d be easy to “manufacture wealth.”

  4. John Ahearn

    The only outstanding question for me is how much of that stimulus actually made it out to the real economy?

    If the money is still stuck as deposits or in risk assets, then borrowing dollars sucks existing dollars thru the fiscal spending channel and it in fact comes out of circulation UNTIL those transfers are spent.

    And bank loan creation shows that if anything, debt is being paid down and dollars are being destroyed to extinguish debt.

    It’s a really weird dynamic, and I think volatility is the real outcome. I think we will eventually see inflation, but not till we see banks willing to engage in credit creation. Till then, I think we swing wildly between both extremes as we attempt to frontrun narratives.

    It really still seems to be a liquidity trap right now. But I’m open to changing my mind if I see follow thru in the next 6 months.

  5. rsm

    《I think that the price level and rate of inflation are literally indeterminate. They are whatever people think they will be. They are determined by expectations, but expectations follow no rational rules. If people believe that certain changes in the money stock will cause changes in the rate of inflation, that may well happen, because their expectations will be built into their long term contracts.》(Fischer Black, “Noise”)

    Why shouldn’t the Fed pay inflation plus 2% on individual CBDC deposit accounts, to encourage individual savings directly?

    Why can’t the Fed directly set market inflation expectations by buying and selling TIPS and inflation swaps, as part of open market operations?

    • Charlie

      Won’t CBDC deposit accounts at the Fed destroy the banking system? USG cannot do that. What am I missing? (Here to learn).

      • rsm

        Does JP Morgan really want my paltry business? Are there a lot of unbanked, that the Fed could serve because the private sector won’t?

        • Joseph Wang

          There are tons of banks around every corner offering free accounts and coffee to any one who wants an account. Fed has none of that – no customer service, no branches no nothing. I have no idea how the Fed would ‘bank’ the public.

          • rsm

            Have you read Robert Hockett’s proposals?

            https://scholarship.law.cornell.edu/facpub/1685/

            《The Fed will administer a national system of ‘Citizen Accounts.’ This will not only end the problem of the ‘unbanked,’ it will also simplify monetary policy. Instead of working through private bank ‘middlemen’ that it hopes will pass QE to borrowers during downturns, the Fed will be able to make ‘helicopter drops’ directly into Fed Citizen Accounts. And rather than relying solely on interbank lending rate hikes or on countercyclical capital buffering during periods of monetary excess, the Fed will be able to impound money through the more carrot-like measure of interest payments it credits to those accounts. Fintech utopians are right that our money is changing, but wrong about what change will look like. It will look like a digital dollar administered by a ‘Citizens’ Fed.’》

          • Joseph Wang

            There is a movement to nationalize the banking system so that only the government decides who gets money – I believe that is the real reason for CBDCs. I don’t believe there is any problem of the ‘unbanked’ – there are banks around every corner offering free accounts to anyone who wants one.

          • rsm

            https://publicbanking.us/federal-legislation/#cbdc

            Is a “public option” non-coercive, voluntary?

            《The central bank’s primary monetary policy tool – Interest On Reserves (IOR) – would be significantly more effective in managing inflation by having a direct immediate impact on bank accounts, rather than being mediated by financial institutions, which allows them to extract profit and divert the impact from the public towards investor profit. 》

  6. Jerry

    The Fed and Federal government know exactly what they’re doing. With unimaginable debt hyper-inflation to pay back that debt in 10-20-30 years with worthless future dollars is quite a scam regardless of the harm it does.

    • T

      What if they don’t pay back the debt and just let it deleverage? I don’t see anything wrong with that, and it’s easier to do that instead of hyperinflate.

  7. Arjun

    Thanks Joseph. Japan has been doing deficit spending plus QE for such a long time. Why have they not been able to generate any inflation? Why will US be any different ?

    • Joseph Wang

      Japan’s fiscal stimulus never approached anything like the US just did. Also note that they suffered from a tremendous bubble that hurt the networth of the corporate and household sector – see Richard Koo’s balance sheet recession view. So a lot the money created plugged holes left by asset value collapses.

      • S

        There have been expectations of asset inflation causing ‘wealth effect’ which in turn causing ‘trickle down effect’ etc.. In the last one decade of QE /debt monetization, this has not come to pass. On fiscal side, effects of (non-deficit funded) Trump’s tax cuts also proved to be fleeting.

  8. S

    Fiscal stimulus (financed with or without deficit spending) causes a fleeting increase in aggregate demand. Coupled with supply chain constraints, it can cause temporary price rise. Ultimately the excess money gets Saved as second order effects of stimulated demand fizzle out.

    Inflation is a different phenomenon, and for it to take root requires:
    – favorable demographics/ HH formation to cause persistent Demand
    – lower individual/pvt sector debt burden
    – willing banks

    • m&m

      interesting, especially last two points: by willing banks you mean those willing to lend to the private sector and thus increase debt burden? wouldn’t the last two point cancel each other out though?
      If QE worked as intended (i.e. banks would lend out more to private sector as a result of QE) then you could get a continuously low interest rate/low inflation environment as long as private sector debt keeps growing at a faster rate than income (and larger share of income goes into servicing this debt, rather than buying stuff in the real economy). But obviously that couldn’t go on for long…

      • S

        “wouldn’t the last two point cancel each other out though?”

        Yes they do. That’s why, unless there is a deleveraging of consumer/pvt sector, Banks will keep pursuing ‘safety’ through Treasuries and Agency securities. QE has dislocated price discovery and elongated the debt cycle.

        QE has lowered the cost of capital and created perverse incentives for financial engineering i.e. stock buy backs. With too much focus on the financial channel and too little on the real economy channel (banks), it seems to have triggered “financialization of entire corporate sector”. Ultimately, the who thing is geared towards retirement – it helps retirees with assets, those with pension plans and many who suddenly find themselves eligible to quite the work force.

  9. Ning

    Interesting publication from your old shop. The conclusion is “Most notably, they find that the view that large-scale purchases of sovereign debt cause unmanageable inflationary pressures is not supported by the experiences of foreign advanced economies.” 🙂

    https://libertystreeteconomics.newyorkfed.org/2021/10/the-international-experience-of-central-bank-asset-purchases-and-inflation/

    • Joseph Wang

      Yes that’s true. From a non-bank perspective, QE simply changes the form of money from sovereign debt to bank deposits. It’s deficit spending that actually creates more money, and is inflationary.

      • S

        Treasuries are ‘money’ when held by private sector and used to borrow and circulate in repo markets. On Fed’s balance sheet they do nothing but sit.

        • Joseph Wang

          Yes, but when Fed buys that Treasury the seller ultimately receives bank deposits, which can circulate through the economy. So the non-bank sector has the same level of ‘money’ just a different composition.

          • rsm

            What if the non-bank sector had no private buyers for their Treasury assets, except at a price far below the Fed’s bid?

            Why is it okay to bail out the private sector from a self-induced panic devaluation of all assets, but not bail out individuals with a fully inflation-proofed basic income?

          • Joseph Wang

            Fed views the world through the lens of rates. It adjusts rates to impact inflation/employment. If rates were too high for their liking then they would just buy the Treasuries, maybe roll out yield curve control like Japan.

            Income stuff is a Congress decision, but Treasury market liquidity is a Fed problem.

  10. Vozmo

    Fed Guy channeling Peter Schiff, or Steve Hanke if you prefer. A most welcome development. BTW I love the long video interviews you’ve done recently. Getting the straight dope from an insider is fascinating, especially when there are so many contradictory assertions circulating on social media.

    • T

      Peter Schiff is a moron in my humble opinion

  11. SH

    Thanks for the article.

    I have a question/issue on this comment “impact of an influx of dollars under a dollar standard is like the discovery of a new gold mine under the gold standard” as I think you need to distinguish between a temporary and permanent expansion of the money supply.

    Under a gold standard, whereby the nominal price of gold is fixed, indeed a supply of gold will be inflationary as the only way the lower real price of gold can be reflected is via the price of everything else going up. However, QE is not analogous to this as QE prints money and lends it into the economy (an asset and liability are simultaneously created) and therefore not necessarily inflationary, as we have seen in Europe and Japan.

    Would a better comparison be to compare the discovery of a new gold mine to helicopter money (i.e. central bank prints and spends on goods and services thereby creating a liability without an offsetting asset and thus ‘devaluing’ the currency)?

    • Joseph Wang

      QE just changes the form of money, it doesn’t increase the amount of money to non-banks. Someone who has a Treasury now has bank deposits instead. It is deficit spending that creates money (the issuance of a Treasury security, which is basically money that pays interest). In practice deficits are forever and only expanding – so Treasuries overall will never be paid down.

      • rsm

        Are you leaving out the trillions of reserves created to swap for private assets, mbs, etc.?

        Didn’t every private agent in 2008 want to exit MBS positions at once, so the Fed created new reserves that were not deducted from anyone’s balance sheet to buy the MBS at above-market, administered prices?

        Do you demonstrate a double standard, where “whatever it takes” is great when it helps out your banker friends, but inflation indexing a basic income is too risky for helping out the little guys?

        Why can’t the public Fed be my friend, too?

      • Vozmo

        About the idea that “QE just changes the form of money,” there is one question which arises in my mind: In an interview with George Gammon, I recall Jeff Snider saying that primary dealer banks create money out of thin air to buy the Treasurys, which are subsequently bought from them by the Fed (during QE) in exchange for bank reserves. The cash from the banks presumably goes into the TGA, which the government then spends into the economy. Is this correct?

        If so, then isn’t QE basically a workaround to allow the government to monetize an increasing amount of debt while keeping a lid on interest rates? And once the government spends the money into the economy, isn’t it increasing the money in circulation, and wouldn’t that be inflationary? If more of the money is going to companies and government contractors then it may not show up in rising prices as quickly as it would when sending stimulus checks directly to financially strapped consumers who will run right out and clear the shelves at Walmart. Maybe it would rather show up in asset prices, the sorts of things those people buy–stocks, bonds, real estate, fine art, wine, etc.

  12. T

    Do you think we will see structural inflation or do you think we will fall back into deflation as Lacy Hunt believes. The US government did not create dollars to fight the pandemic, they BORROWED dollars in the form of loan creation through deficit spending.
    So Lacy says we’ll see a one time burst of inflation as money that was borrowed gets spent but that will eventually get drained and then since we borrowed money for a non-productive enterprise and for consumption, that eventually leads to more disinflation/deflation and growth stagnation.

  13. Nikaya

    Thanks for writing such wonderful book, it makes the opaque subject of Central Bank operation understandable for general public. The focus of the book and this blog has been on recent events, which is entirely understandable since the financially system has undergone drastic changes. This made me wonder if there was any strain showing up in the financial system prior to the 2000’s dot com bubble. Was there any bank run on MMF or other funding market as trades were being unwind in the early stage of the crash? What would be the good stats or economic indicators if I want to look into this?

    • Joseph Wang

      Good question. I don’t think the tech bust had much of an impact on the financial system because the linkages were not strong. The banks and dealers were not taking investing in tech equities. Bank are conservative investors and usually don’t invest in stocks, but instead invest in secured loans. If you are concerned about the health of banking system a good indicator is the spread of 3M LIBOR and OIS, or the publicly available Treasury bill to Libor spread. This shows how stressed the banking system is (bank borrowing costs benchmarked against US gov borrowing costs). When the spread widens there is stress in financial system.

  14. Ed Giorgio

    Are these homeowners going to:
    – leave the money in checking accounts for a rainy day
    – pay off debt (credit cards, car loans, mortgages, HELOCs, student loans)
    – invest in stocks and bonds and further inflate prices
    – purchase nondurable and/or durable goods
    – make a downpayment on a house

    Only the last two are inflationary

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