The impact of monetary base growth on the value of the US dollar

The unorthodox monetary policy of quantitative easing being pursued by the Fed in response to the global financial crisis has, of late, caused widespread speculation that out-of-control inflation will erupt in the world’s largest economy and significantly weaken the value of the US dollar.

Although Treasury Secretary Timothy Geithner continues to reassure stakeholders of his policy to keep the dollar strong and return the US to fiscal responsibility, downward movements in the dollar continue to cause alarm for many countries that peg their currencies to the dollar and for countries that hold sizeable positions of US assets. The role of the greenback as a global reserve currency has also been called into question by many politicians and economists as concerns over US monetary policy and worldwide debate over how to govern the international financial system has intensified.
 
Fear of the dollar’s declining relevance in the world is alive and well. Is it warranted? Will quantitative easing lead to unmanageable inflation? Let’s examine the facts and consider the theories.
 
Response to the financial crisis
The current financial crisis, which started with the collapse of the US housing market in 2007, has led the US government and the Fed to spend, lend or commit trillions of dollars in a valiant effort to breathe life into the economy and revive credit markets.
 
By pursuing a policy of quantitative easing, where a central bank creates money to purchase assets, the Fed’s balance sheet has ballooned from US$904bn at the end of 2006 to US$2.1tr at the end of August, an increase of over 130 per cent. See Figure 1. The Fed’s aggressive decision to buy over US$1.2tr in mortgage-backed securities, agency debt and even long-term government bonds was necessary to lower borrowing costs after its benchmark Federal Funds target rate was cut to near zero and did virtually nothing to stimulate credit flows.

Will inflation emerge?
In economics the quantity theory of money, in its basic form, states that the quantity of money in circulation will determine its value. The theory would have one believe that flooding the system with currency will lead to inflation, or even worse hyperinflation, as more money chasing the same amount of goods and services drives prices upward. Increasing the amount of currency, i.e. printing money, without increasing the value it represents makes it worth less. This has always been the concern with a fiat money system, a system where money is not backed by gold or other commodities but instead the full faith of the issuer.
 
Since March, investors have drifted out of the US dollar, which was a haven for much of the crisis, to seek assets with higher returns, leaving the dollar 12 per cent off its 9 March peak at the time of writing. It appears as though the dollar has resumed its downward trajectory versus its major trading partners; a path started over the past seven years. See Figure 2. Considerable uncertainty remains over the dollar’s future. Is it headed toward a massive devaluation?
 
 
 
I don’t think so. Despite aggressive monetary policies implemented by the Fed and the massive injections of money into the system, inflation has yet to emerge. As shown in Figure 3, the Core CPI measure, which excludes volatile items like food and energy, shows that inflation has barely budged from trend. Using Headline CPI or the PCE deflator, which is the Fed`s preferred inflation gauge, prices have been very clearly contained. In fact, a Japan-style deflation scenario is still conceivable if aggregate demand remains muted for a lengthy period of time.
 
Nonetheless, it would be naïve to believe that long-term hyperinflation – and consequently dollar devaluation – is impossible by simply analysing current price indices. Besides, with the world economy in recession, unemployment rising and most housing markets in decline, one would expect prices to be stable if not falling.
 

 
Effect of quantitative easing
 
A stronger argument against the risk of hyperinflation is the fact that the doubling of the Fed’s balance sheet has not resulted in a sustained explosion in the broader money supply, referred to as M2. In fact, recent statistics even show a sharp deceleration in M2 growth.
 
How can this be? Is the quantity theory of money flawed?
 
No, not at all. Here’s why. The ‘printed money’ is sitting largely on commercial bank balance sheets as excess reserves in exchange for assets held by the Fed. The remarkable increase in these excess cash reserves was primarily due to risk aversion and the extraordinary de-leveraging process that has taken place since the beginning of the crisis. So instead of the ‘printed money’ making its way into the hands of consumers and businesses, and wreaking havoc on price levels, it has mostly sat on the sidelines at the Fed itself, where commercial banks keep their excess reserves. As Figure 1 depicts, much of the increase in the Fed’s balance sheet, nearly 70 per cent in fact, is due to an increase in the excess reserves of depository institutions.
 
The corresponding lack of credit expansion by commercial banks, and its would-be multiplier effect on the broader economy, has transpired either because commercial banks have changed their lending behaviour or because business and consumer demand has been sluggish. Either way, the velocity of money in the economy, a closely watched indicator and an element of the quantity theory of money, has not risen despite massive amounts of cash being pumped into the banking system. As you can see from Figure 4, the rate at which money changes hands has declined substantially. Quite simply, the money pumped into the banking system has not circulated throughout the economy.
 
So, one can reasonably deduce from all of this that quantitative easing only becomes problematic to price levels under one scenario. And that is if excess demand for goods and services is created which in turn causes the circulation of money through an economy to increase. It is only then that price levels start to spiral out of control.
 

 
Can the Fed tighten when necessary?
 
When the economy eventually turns around, and demand growth emerges, will the Fed be able to extract the massive amount of liquidity it has injected? One has to have faith in the Fed to answer yes to this. Recently re-appointed Chairman Ben Bernanke has assured the American public that he can, and will, succeed in its exit strategy. I see no reason to disagree. The Fed has political independence and the tools at its disposal to employ quantitative tightening. Just as the Fed giveth, the Fed also taketh away. And, unlike fiscal policy, this can happen quickly. By selling assets back to banks and issuing its own debt, the Fed can remove liquidity from the system. To the surprise of many, Fed officials have already started to carefully phase out some programmes.
 
It is for all these reasons that I don’t see long-term devaluation in the dollar as a result of recent quantitative easing programmes.
 
Now you may be wondering about the impact of fiscal stimulus on the dollar? Well, that’s a whole other story. But I’ll end by saying that history has shown that both large government deficits and high debt levels can be followed by either deflation or inflation.

The views expressed above are not necessarily those of Butterfield Bank (Cayman) Limited.