This suggests that there must have been another growing demand for base currency that kept quantitative easing from spilling over to inflation.
While banks are the residual holders of the face value of base money (not held as money by the public), they can certainly adjust it in real terms by causing inflation.
Banks can lend money for any reason, including for investors in securities, or they can use it directly for currency trading. Money would flow from bank to bank until the effects of wealth and currency depreciation drive up inflation and reduce the real value of the base currency. But that did not happen.
The growing demand for highly liquid assets was caused by financial re-regulation after GFC. This has increased the cost of global systemically important banks using their balance sheets in open positions, while the shadow banking industry has not been subjected to these pressures.
This prompted GSIBs to adjust their business models to focus more on institutional clients less constrained by regulation. Their income is now more driven by chains of collateralised positions with parallel banks for fees, commissions and spreads than by traditional consumer banking.
GSIBs hold high levels of liquidity because they need to maintain market confidence in their business and because liquidity coverage ratio regulations require them to do so as the size and complexity of their business increases. .
Without QE easing this demand, interest rates would have increased, limiting the shift in leverage risk towards shadow banking.
QE did not cause high inflation in 2021 due to a cumulative monetarist lag of 14 years – suddenly everything is happening at the same time.
The graph shows the basic PCE deflator and the weighted sum of services inflation (labor cost drivers) and import prices (including the exchange rate driver). When the gap between the latter (shaded) and actual inflation widens (the empty area in between), then something else happens, causing inflation to accelerate on top of these basic factors. .
The COVID-19 pandemic has made it more difficult to find workers and move things.
Typically, this is a pressure on the supply chain (represented by inventory in the graph) that requires higher price incentives to be addressed to resolve.
The 2008 recession saw the effect of service and import prices drop to zero, while a broad fiscal response was put in place. This surge in demand led to a sharp drop in inventories. Pressure on exhausted supply chains has driven prices up.
The downward trend in inflation caused by the global supply shock to China continued, but this cyclical rebound brought inflation down to 2% on a transitional basis.
The latest COVID-19 recession is eerily different. The strong expansion of the budget deficit (see bottom line of the graph) is larger than that of the GFC. But this time around, it’s combined with an atypical disruption of global supply chains.
Far from declining, the contribution of services and import prices has skyrocketed and real inflation is even higher, suggesting additional unusual supply pressures. The inventory variable has decreased by almost double that of the GFC period.
The COVID-19 pandemic has made it more difficult to find manpower and move things around due to closures, vaccination programs and fear.
Transportation has become difficult. Supply chain shortages abound in semiconductors and production components, which extend more broadly to all goods and services. With the Delta variant still booming and the Omicron becoming a factor, these aspects will not be short lived.
This situation is exacerbated by the growing conflict with China, which has now announced its âdual circulationâ strategy, focusing on the domestic economy. Its contribution to global savings is renewed due to demographic aging, at the same time when Western countries have understood that national security requires a higher level of self-sufficiency.
This restructuring of supply chains requires higher prices and margins and will take much longer. Inflationary pressure is expected to be more persistent as the world shifts gears.
An important aspect of this realignment is the ex ante savings-investment imbalance. Investments in infrastructure are needed just as budget deficits are high in the western world following the pandemic. The deployment of Chinese investments will become increasingly absent in the West.
Real interest rates have only one way to go, and investors need to make it part of their portfolio thinking now.
Real US 10-year bonds fell from 1.5% to 2.8% during the 2008-2009 period. In October of this year, the real rate was -2.5 percent.
The Fed and central banks elsewhere must stop swaying real interest rates away from those required by the current real pressures on savings and investment. They are very late to do so.
As rates rise, the past adaptation of GSIB’s business model is through QE, increasing leverage in the shadow banking sector, this will likely be a rebound for banks, shadow banks and investors bond.