Sunday, November 7, 2021

We just don't know much about inflation and money


I thought I knew about the causes of inflation and the link with money. I don't, but then others don't either. The conventional story is that higher money growth through QE should lead to lead to higher economic activity and then higher inflation if economic slack is diminished. The link may exist, but the sensitivities between money, growth and inflation are unclear.  

We do have pre-COVID history from the BOJ, BOE, ECB, and the FED on massive QE programs with little evidence that inflation has greatly exceeded targets. We also have evidence that the money multiplier in all cases has fallen. The link between money and GDP has not been unstable rather it has been suggesting a desensitized relationship. See The International Experience of Central Bank Asset Purchases and Inflation by Gianluca Benigno and Paolo Pesenti.


Given this international evidence on QE around the world, what should we expect from tapering? We have less evidence of what will be happen, yet quantitative tapering will be the dominant theme with central bank policy over the next few quarters. In the case of the Fed, ending QE rounds and tapering have been associated with declining rates although these were periods of low inflation and lower debt financing.


The Fed has stated that tapering is not linked to rate increases, yet can we say with any certainty that tapering will be market neutral? Will tapering have only limited effect on fixed income and risky markets? Right now, the view is that reducing purchases are market impact neutral. We have yet to consider an actual reduction in the Fed's balance sheet. 

I am for a reversal of monetary excesses, yet my fear is that we are not clear on the market consequences. This tapering offers fixed income traders both opportunity and risk through betting against the status quo as we receive feedback on the cutback of purchases. Despite trying to delink tapering from rate moves, the two are naturally linked. Rate increases in the short to mid-maturities can be anticipated from fewer Fed purchases regardless of the Fed's forward guidance. 


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