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CNF Focus| Inflation will come eventually

Inflation will come eventually

After the oil crisis in the 1970s, the U.S. inflation pivot has moved downward, with the CPI lowering from a level of over 7% year-over-year to less than 2%. Since 2008, the Fed's balance sheet has continued to expand while failing to push up inflation, leaving most people skeptical of the relationship between currency and inflation. Many people therefore infer that the extremely easing monetary policies of central banks this year have difficulty in triggering higher inflation. But considering the reasons behind it, this time it may be different from 2008 financial crisis, and the inflation pivot is expected to rise significantly in the future.

Exhibit 1. U.S. Core CPI Trend

Exhibit 2. the Federal Reserves Balance Sheet Trend

In the 10 years from 2008 to 2018, the Federal Reserve's balance sheet increased by about $3.55 trillion, roughly equal to the amount of base currency the Fed put into the market.[1] Where did all those dollars go and why didn't they trigger inflation?

1. Remained in the financial system

Before the 2008 financial crisis, the Federal Reserve did not pay interest on banks’ excess reserves. As a result, banks basically do not deposit excess reserves with the Fed on the basis of meeting statutory reserves. As of the end of 2007, the size of excess reserves deposited by depository institutions at the Federal Reserve was only about $2 billion. In order to adapt to the zero interest rate environment and enhance its ability to regulate the federal funds rate, the Federal Reserve announced that interest would be paid on deposit reserves (including statutory and excess) since October 15, 2008. [2] The excess reserve rate is roughly 10 basis points higher than the federal funds rate. Because of the Fed's excellent creditability and the reasonable interest return, banks are very happy to deposit funds in the Fed system.

On the other hand, in order to solve the regulatory issue reflected in the 2008 financial crisis, central banks strengthened the supervision of financial institutions. On July 21, 2010, the Dodd-Frank Act was signed into effect by then President Barack Obama as the result of U.S. financial regulatory reform.[3] On September 12, 2010, 27 countries agreed on the contents of Basel III, and the global banking industry entered a new era of regulation.[4] Both acts imposed higher capital adequacy and liquidity requirements on banks, and banks had to increase their deposit reserves to comply with the new regulatory requirements.

Exhibit 3. Trends in Reserve balances of U.S. depository institutions (Million $)

Under the dual impact of the increase in deposit reserve earnings and the strengthening of financial supervision, the reserve balance of U.S. depository institutions increased by approximately $2 trillion in the 10 years from 2008 to 2018. [5] This means that more than half of the $3.55 trillion in currency issued by the Fed has been deposited back to the Fed and has not been circulated in the market.

2. Flooded into assets instead of consumption

Generally speaking, the poor are more inclined to consume when they receive income, while the rich prefer to invest. If the money printed by the Fed gets into the hands of the rich, it will be more likely to trigger asset bubbles rather than inflation. The gap between rich and poor in the U.S., which has been widening since the 1970s, is now at almost its highest level in history.

Exhibit 4: Trends in the U.S. Gap between Rich and Poor

While inflation in the U.S. has remained low since 2008, U.S. assets have enjoyed a superb bull market. The U.S. house price index of large and medium-sized cities grew at an average annual rate of 5%, the S&P index grew at an average annual rate of over 10% and the NASDAQ index at over 14%, all significantly outperforming inflation. A large portion of the currency issued by the Fed was used by the wealthy to purchase various assets rather than circulating in the consumer market.

3. Outflow to other economies

Emerging economies exported a large number of cheap goods to the U.S. due to their low labor costs, which has significantly depressed U.S. inflation. After China's accession to the WTO in December 2001, U.S. imports from China rose rapidly, accompanied by a rapid decline in the U.S. core CPI[5]. This shows that the globalization of trade reduces the cost of goods and is one of the important reasons for low inflation in the United States.

The Fed did put in a large amount of base currency. More than half of these dollars flowed back to the Fed in the form of deposit reserves, and some were used by the rich to invest in assets. As a result, the currency that actually circulates in the consumer market is far less exaggerated than the Fed’s balance sheet appears to be. Meanwhile, the globalization for the past 20 years has reduced the cost of goods. Therefore, inflation in the United States has been able to remain low since 2008.

In 2020, the Fed's balance sheet has greatly expanded again. Why is this time different from 2008? Because all the three reasons mentioned above for suppressing inflation are changing.

Since the 2020 crisis was triggered by the COVID-19 rather than the financial system, countries have no plans to revise financial regulations for the time being. Ten years after the enactment of Basel III and the Dodd-Frank Act, the ratio of reserves deposited with the Fed by the banking system has entered a relatively stable state. As of the end of 2020, the proportion of US depository institutions' reserve balances in the balance sheet of the Fed has stabilized at about 0.4[5]. This means that most of the currency issued by the Fed this time has not flowed back into the Fed system.

Exhibit 5: Depository institution reserve as a percentage of the Fed’s balance sheet

In the 2008 financial crisis, the U.S. bailout was focused on ensuring the stability of the financial system. This time, the fiscal policy and monetary policy of the United States have coordinated unprecedentedly. On March 27, the U.S. stimulus bill of $2.2 trillion was introduced. On April 25, an additional bill of $483.4 billion was added to focus on payrolls and health care [5]. These fiscal plans contain a lot of "helicopter money", such as cash checks for everyone. While it is difficult to prevent these dollars from flowing into assets such as stocks, the scale of assistance provided directly to the poor is not achieved by any past stimulus policies. More importantly, as the president of the Democratic Party, Biden advocated policies to narrow the gap between rich and poor, such as increasing taxes on the rich and increasing basic welfare. If there is an inflection point in the wealth gap, it will directly reverse the current ratio of money flowing to assets and consumption.

Last but not least, trade globalization has entered a new phase. Since the U.S.-China trade war, the average tariff level between the U.S. and China has risen from 3% to 20%. After the outbreak of COVID-19, many developed countries realized the importance of maintaining their own industrial chains. On January 25, 2021, Biden signed the "Buy American" executive order, which requires the government to increase its purchases of U.S.-made products and services by $400 billion within four years [6]. If implemented successfully, this plan will improve the U.S. trade deficit, but may increase the cost of domestic consumption.

While inflation is still low, inflation expectations are already rising rapidly. On January 15, 2021, a survey by the University of Michigan showed that consumers’ 1-year inflation expectations were 3%; the long-term inflation expectations were as high as 2.7%, the highest level since 2014. According to the inflation expectations implied by Treasury Inflation-Protected Securities (TIPS) and regular Treasuries, the current 5-year and 10-year implied inflation rates are 2.18% and 2.1% respectively, basically returned to the high point in April 2018 [7].

Potential impact of the arrival of inflation

From the history of monetary policy adjustment, the Fed pays more attention to the actual improvement in employment, and inflation exceeding expectations will not necessarily lead to a interest rate hike. Investors need to be aware that even if the Fed keeps the short-term nominal rate at 0%, it does not affect the 10-year Treasury rate to rise sharply. At present, the 10-yearTreasury rate has risen above 1%. If inflation rises more than expected, long-term bond rates may continue to rise, even close to 2%. This situation will deal a heavy blow to risky assets such as stocks and have a supporting effect on anti-inflation assets such as gold.

If the rise in long-term bond rates hinders the economic recovery, the Fed may activate another powerful tool - "yield curve control" (YCC). Under YCC, the Fed would declare a ceiling on long-term interest rates and guarantee that long-term interest rates will not rise above the target by a promised purchase. If YCC is really implemented, it would bring confidence to the market and upward momentum to assets.

Both the arrival of inflation and the implementation of YCC require a lot of data validation and extensive discussion. In a longer period, inflation and interest rates are significant factors affecting the trends of assets such as gold and stock indices. If investors can track the turning point of market expectations of these core factors, they will be able to expect good returns.

References

[1] Recent balance sheet, the Federal Reserve

https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm

[2] 郭建,新浪财经,《美联储十年降息简史》

https://finance.sina.com.cn/money/forex/forexinfo/2019-09-20/doc-iicezueu7123599.shtml

[3] MBA智库,《多德-弗兰克法案》

https://wiki.mbalib.com/wiki/%E3%80%8A%E5%A4%9A%E5%BE%B7-%E5%BC%97%E5%85%B0%E5%85%8B%E6%B3%95%E6%A1%88%E3%80%8B

[4] MBA智库,《巴塞尔协议III》

https://wiki.mbalib.com/wiki/%E5%B7%B4%E5%A1%9E%E5%B0%94%E5%8D%8F%E8%AE%AEIII

[5] 沈新凤,尤春野,东北证券,《一切通胀仍是货币现象》

https://pdf.dfcfw.com/pdf/H3_AP202010141421290300_1.pdf?1602686820000.pdf

[6] 魏之,美国之声,《拜登签署行政令“买美国货”》

https://www.voachinese.com/a/biden-buy-american-20210125/5751798.html

[7] 李超,浙商证券,《TIPS隐含美国通胀到了多少?》

https://www.stocke.com.cn/ueditor/jsp/upload/file/20210125/1611534517481047808.pdf

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2021/02/05
CN First International Futures Limited