A Perspective on Stagflation 2011

The Fed says inflation is under control, but the price at the pump and grocery check out is indicating otherwise. Why? Stand IERP fellow Ronald McKinnon suggests that ZIRP-the zero interest rate policy the Fed has held for the past two years-has caused inflation in emerging markets, impacting food prices:

Wanting to avoid sharp appreciations of their currencies and losses in international competitiveness, many Asian and Latin American central banks intervened to buy dollars with domestic base monies and lost monetary control. This caused a surge in consumer price index (CPI) inflation of more than 5% in major emerging markets such as China, Brazil and Indonesia, with the dollar prices of primary commodities rising more than 40% world-wide over the past year. So the proximate cause of the rise in U.S. prices is inflation in emerging markets, but its true origin is in Washington.

He also notes that the increase in reserves at banks and expansion of the Fed balance sheet by buying assets combined with ZIRP has decreased willingness to lend, creating economic constraints:

Since July 2008, the stock of so-called base money in the U.S. banking system has virtually tripled. As part of its rescue mission in the crisis and to drive interest rates down, the Fed has bought many nontraditional assets (e.g., mortgage-backed securities) as well as Treasurys. Yet these drastic actions have not stimulated new bank lending. The huge increase in base money is now lodged as excess reserves in large commercial banks.

In mid-2011, the supply of ordinary bank credit to firms and households continues to fall from what it had been in mid-2008. Although large corporate enterprises again have access to bond and equity financing, bank credit is the principal source of finance for working capital for small and medium-sized enterprises (SMEs) enabling them to purchase labor and other supplies. In cyclical upswings, SMEs have traditionally been the main engines for increasing employment, but not in the very weak upswing of 2010-11, where employment gains have been meager or nonexistent.

Why should zero interest rates be causing a credit constraint? After all, conventional thinking has it that the lower the interest rate the better credit can expand. But this is only true when interest rates-particularly interbank interest rates-are comfortably above zero. Banks with good retail lending opportunities typically lend by opening credit lines to nonbank customers. But these credit lines are open-ended in the sense that the commercial borrower can choose when-and by how much-he will actually draw on his credit line. This creates uncertainty for the bank in not knowing what its future cash positions will be.

… If the retail bank has easy access to the wholesale interbank market, its liquidity is much improved. To cover unexpected liquidity shortfalls, it can borrow from banks with excess reserves with little or no credit checks. But if the prevailing interbank lending rate is close to zero (as it is now), then large banks with surplus reserves become loath to part with them for a derisory yield.

Read the rest of the piece from WSJ here.