One of 2021’s biggest financial stories is the comeback of inflation. It may be transitory, as the Federal Reserve has been stating, or more sinister, like the kind of increases that fueled the 1970s price movements.
Why Might It Be Transitory?
The Federal Reserve’s transitory theory is that the Covid virus caused massive shutdowns and dislocations. Then, when economies reopened, there was an enormous increase in demand. However, the previous year’s shutdown hindered the supply of goods.
The problem for the Fed is that, as price increases continue or worsen and last longer, their previous time frame of transitory gets pushed out.
What About All This Government Spending?
In March 2020, the government passed the $2.2 trillion CARES Act. In April, $484 billion was approved to fund the Paycheck Protection Program. Finally, in August, the Consolidated Appropriations Act, 2021, passed, providing $900 billion.
In March of 2021, newly elected President Biden signed into law an additional $1.9 trillion, bringing total government expenditures on Covid relief to roughly $5 trillion, an astonishing 25 percent of GDP spent.
Where Does New Money Come From?
You might be surprised that government spending usually has little impact on the supply of money. This is because the government gets its money by taxing. If its spending is higher than its revenue received through taxation, it sells bonds to make up that difference. Either way, the money the government gets that it redistributes was already in the economy.
Most new money in a capitalist economy comes when a non-government entity, a commercial bank, makes a loan. In that case, it credits the loan applicant with a new deposit offset by a new liability on the loan. As a result, the bank customer is free to spend that money. Because that new deposit was not drawn from someone else’s bank account, it is new money.
Enter Quantitative Easing
The difference with this recent massive increase in government spending is that most of it was offset when the government’s bank, the Federal Reserve, bought it.
The government sells the bonds to primary dealers in an auction. The primary dealers either keep those bonds or sell them to pension plans, individual investors, mutual funds, etc.
Again, this process has no impact on the supply of money. The bank account drafts of the primary dealers or buyers of the bonds are entirely offset by the credits in the bank accounts of the recipients of the government spending.
However, if the government tried to sell $5 trillion of new bonds in the middle of an epidemic-fueled recession, it might have had to offer a higher interest rate on those bonds, which could increase the rate on other bonds—something they wanted to avoid.
To reduce the likelihood of that outcome, the Federal Reserve promised to buy those bonds from either a primary dealer or the entity that bought them from the primary dealer.
Read More: The Federal Reserve
Here Is Where It Gets Complicated
When the Federal Reserve buys a bond from a noncommercial bank like a primary dealer, a pension plan, or a mutual fund, it credits that entity’s bank with new money called reserves. That bank then credits the bond seller with a new deposit. That new deposit is considered new money as nobody’s bank account is reduced by an equal amount. The same process occurs when making a loan.
Is the Fed’s bond-buying the inflation culprit? Probably not. If it is playing a part, it is indirect. Most of the new money created by commercial banks probably went back into financial assets like stocks and bonds, which helped push up their prices. In a process called the wealth effect, owners of those assets might use their increased wealth to buy non-financial assets like houses, paintings, and cars, but this probably will not push up the price of food, gas, or other commodities.
These are the opinions of Tim Hayes and not necessarily those of Cambridge Investment Research. They are for informational purposes only and should not be construed or acted on as individualized investment advice.