Fama on the Fed and Inflation


I don’t agree with Eugene Fama on everything, but I’d be a fool if I didn’t agree with him on quite a bit. Fama wrote the paper which, back in the early 1980s, pointed out that if you modeled inflation as a result of monetary factors and Keynesian factors (unemployment, e.g.), the Keynesian factors didn’t add anything. Since then, economists have pretty much forgotten that lesson, so that we have to continually battle the Keynesian “let’s just expand government spending” crowd.

Many of his views about efficient markets are pretty extreme, and that’s where I can’t agree wholeheartedly. However, I read with interest the discussion between Fama and Bob Litterman in this month’s issue of the Financial Analysts Journal. The full interview, called “An Experienced View on Markets and Investing,” is located here, and since the FAJ has made the entire interview available for free I am going to quote liberally from the last page. Indeed, I am going to print three of the last four questions, because they correlate exactly to things I have written in this space, and echo almost exactly the views I have expressed. Considering Fama is one of the godfathers of modern finance, I take this as indication I am on the right track, at least sometimes.

In the passages below, I have added all the emphasis marks.

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Litterman: What impact will the big expansion in the Federal Reserve’s balance sheet have on the markets?

Fama: It has basically rendered the Fed powerless to control inflation. In 2008, when Lehman Brothers collapsed, the Fed wanted to get the markets moving and made massive purchases of securities. The corollary to that activity, however, is that reserves issued by the Fed and held by banks exploded. An explosion in reserves causes an explosion in the price level unless interest is paid on the reserves. So, the Fed started to pay interest on its reserves, which means that the central bank issued bonds to buy bonds. I think it’s a largely neutral activity.

Before 2008, controlling inflation was a matter of controlling the monetary base (currency plus reserves). But when the central bank pays interest on its reserves, it is the currency supply that determines inflation. But banks can exchange currency for reserves on demand, which means the Fed cannot control the currency supply and inflation, or the price level, is out of its control. The Fed had the power to control inflation, but I don’t think it does under the current scenario.

[Ashton’s note: Fama identifies why the monetary base is no longer tied to inflation – the link to transactional money has been severed thanks to IOER. See some of my remarks on this here.]

Litterman: But isn’t one way out of our debt problem to inflate it away?

Fama: Yes, that’s one way to handle it, but it’s far from a great solution. If the Fed were to stop paying interest on its reserves, we’d probably have a big inflation problem. The monetary base was about $150 billion before the Fed stepped in in 2008. Currency plus required reserves are still in that neighborhood, but the Fed is holding $2.5 trillion—trillion!—worth of debt financed almost entirely by excess reserves. The price level could expand by the ratio of those two numbers, and that translates into hyperinflation. Economies typically do not function well in hyperinflation. The real value of the government debt might disappear, but the economy is likely to disappear with it.

Litterman: What would your suggestion be for monetary or fiscal policy at this point?

Fama: Simple. Balance the budget. I heard a very prominent person say in private that we could balance the budget by going back to the level of government expenditures in 2007. The economy is currently about the size it was then. If you just rolled expenditures back to that point, I think it would come close to balancing the budget.

[Ashton’s note – just this month, I commented that all you have to do to get the budget back into a semblance of balance was to reverse most of the things that were done over the last decade.]

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The whole FAJ article is pretty good, but I wanted to make sure that everyone caught this part of it!

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  1. Jan Robyns
    December 11, 2012 at 4:08 am

    Hi Michael, great blog and I am a big fan. One note/question on Fama and his assertion inflation would jump by the ratio of the old divided by the new monetary base. That would only be the case if the ‘money multiplier’ AND ‘velocity’ would in 1 go jump back to 2008 levels which is unlikely. Wouldn’t you agree with John Hussman’s writings on this topic for example in ‘Sixteen cents’ (http://www.hussmanfunds.com/wmc/wmc110124.htm).

    • December 11, 2012 at 7:41 am

      Thanks for the note, Jan! I agree that hyperinflation is very unlikely, and for the reasons you say. I think we could pop the multiplier back up pretty quickly, if we implemented a sharply negative IOER, but velocity would likely recover much more slowly (and perhaps not at all). There is a table in the article I linked to above (What Keeps Me Awake At Night) that shows what sort of inflation bump you’d get if velocity and the multiplier moved to various levels over two years. You clearly can get a number that’s hyperinflation-lite, in the right circumstances…and even if the multiplier alone moves, you can get pretty big figures.

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