Inflation has managed to rise to the top of ‘most discussed’ topics for the US economy, and to a lesser degree some of the world’s economic powerhouses.
In less than the time it’s taken me to write this article, concern has swung from economic contraction to too much pent up expansion; neither have quite managed to deliver the extremes envisaged. I am of course speculating on the expansion front, as we have a little way to go yet!
On one hand you have the conspiracy theorists who say that the US has written so much debt that one sure fire way of reducing that debt is by fuelling inflation, after all why repay today what in 10 years will be halved in cost? Nice idea, but…
To appreciate this is partly to understand another reason why inflation fears are overstated. The Federal Reserve’s balance sheet has expanded to $2.055 trillion from $871 billion last May. The expansion has been financed primarily in two ways: Extra Treasury bill issuance by the Treasury Department which is in essence given to the Fed, and by creating reserves, “printing money” in the vernacular. Therein is where many see the inflation risk.
The reserves in excess of what is required, hence they are called “excess” reserves, are the fuel for inflation. The key though seems to be what the banks are doing with these reserves. The short answer: nothing. The banks are sitting on a virtual mountain of excess reserves which are kept with their creator, the Federal Reserve itself. In the most recent two-week bank statement period, these excess reserves stood at almost $800 billion, a little more than the entire TARP allocation. Prior to the crisis, excess reserves were minimal—a couple of billion dollars. What this means is that nearly two-thirds of the dramatic expansion of the Fed’s balance sheet that so worries many investors is still with the Fed itself. It is not chasing assets or goods. It has not truly entered the circuit of capital. In essence, the inflation risk is being exaggerated because the “real effective” expansion of the Fed’s balance sheet is being exaggerated.
So where is the dollar heading if inflation is not going to happen? Short term down, medium term could see the dollar outperform? The further the dollar falls now the greater the chances are that the export effect will have on lengthening the timeframe of recovery for the export driven economies, think Japan, Germany (and Europe) which has had a relatively low level of stimulus pumped into their markets and a rather large reliance on exports. They will ultimately have less of a rollercoaster ride, but will have to also endure a longer term of mediocrity, no pain, no gain.
The real kicker could be a hike in US rates before the rest of the world is in a position to catch up (excluding Australia which never technically experienced a recession). If the Fed starts hiking rates in Q2 2010 (my choice) then we could see some traction in dollar gains – market leading economic turn around coupled with higher rates and rosy prospects – what’s not to like?