Why disinflation is the real worry

NRPLUS MEMBER ARTICLE

I
t is time to start worrying about inflation? For some observers, the answer is an emphatic yes. They fear the drastic steps policymakers are taking to keep the economy afloat during the COVID-19 crisis are pushing government finances to a tipping point, one where soaring inflation will once again rear its ugly head.

It is true that the stock of marketable treasury securities is likely to reach $21 trillion this year, causing our national debt to exceed the size of the economy. The Federal Reserve, meanwhile, is expected to expand its balance sheet to almost $10 trillion this year as it buys up vast amounts of assets and backstops almost every major market. It is understandable that these extraordinary developments should cause some to worry that inflation is about to surge.

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Financial markets, however, are telling a very different story. Interest rates on long-term treasury bonds are at record lows, indicating expectations of low inflation over the next decade. Similarly, the value of the dollar against a broad basket of currencies has risen and remains elevated. These and other market indicators suggest that declining rates of inflation lie ahead.

For market participants, then, the real threat they see posed by the COVID-19 crisis is the emergence of disinflationary pressures. This outcome may seem counterintuitive given the runup in public debt, but it is a natural consequence of at least three crisis-related developments that significantly raise the demand for treasury securities and other dollar-denominated assets.

Twice Bitten, Super Shy

The first one is that the COVID-19 pandemic has spawned a generation of more risk-averse investors. Studies have shown that individuals that experience sharp recessions are more cautious with investments over their lifetimes. They tend to hold fewer stocks in their portfolios and invest more in safe assets like U.S. treasury securities. They also tend to save more overall.

Millennials, in particular, have now experienced the Great Recession of 2007-2009 and the COVID-19 recession. These two painful experiences should push them to invest more in safe assets than otherwise would be the case. This increased risk aversion by Millennials, the next big cohort in advanced economies, will add further pressure to the already heightened demand for safe assets coming from an aging Boomer generation, emerging markets, and financial regulations.

This existing demand for safe assets is one reason why interest rates on long-term U.S. treasury bonds remain very low despite the large runup in public debt this year. It also helps explain low inflation, since the increased demand for safe assets means less spending. A new generation of more risk-averse investors will add to this already elevated demand for safe assets and create additional disinflationary pressure that will be with us for some time.

Federal Reserve Branch Banking

The second development that should increase disinflationary pressures is that the Fed has taken steps that have permanently increased the demand for dollars abroad. This increased demand for dollars, in turn, creates additional revenue for the U.S. government since it can produce dollars at virtually no cost. The dollars, in turn, can be sold to foreigners for real goods and services. The revenue, called seigniorage, allows the U.S. government to run larger deficits without generating inflation.

So how did the Fed pull this off? It did so by opening up its balance sheet to foreign central banks in two steps. First, it expanded who could have access to dollar swap lines from five to fourteen countries. These swap lines allow nations to temporarily swap their currency for dollars. Second, the Fed set up a new facility that allows foreign central banks to temporarily trade U.S. treasury securities they hold for U.S. dollars. The Fed, in short, effectively set up temporary branch offices in central banks around the world by granting them access to its balance sheet.

This access allows foreign central banks to provide dollars to their economies when the demand for dollars spike, as they have during this crisis. Dollars are widely used overseas, even in advanced economies, and its use makes more foreign economies susceptible to financial crises. Banks in Europe, for example, have large dollar liabilities on their books. Consequently, during a financial panic these banks demand more dollars, but the European Central Bank (ECB) cannot create new dollars to help them out. The ECB can, however, temporarily trade euros or U.S. treasuries it owns to the Fed for dollars and, in turn, lend them out to these European banks. This access provides temporary dollar liquidity to distressed banks outside the United States.

The Fed provided this same access in the 2008 crisis, but on a smaller scale. The fact that the Fed has opened up and expanded this dollar access to the world sends a strong signal to foreign investors. It tells them that it is okay to hold more dollars in their portfolios since the Fed will reopen its temporary branch offices should another financial crisis arise in the future. The Fed does this to prevent dollar runs abroad from bleeding into the U.S. economy. In so doing, though, it has actually strengthened the demand for dollars abroad and increased the future flow of seigniorage to the U.S. government.

Biggest Kid on the Block Got Stronger 

The third development is that the COVID-19 crisis should actually strengthen the role of the U.S. financial system in the global economy and, in turn, further bolster the demand for dollar-denominated assets. This outcome may appear contrary to the financial stress observed over the past few months, but it is likely given the outsized role played by the U.S. financial system and the Fed’s support of it during the crisis.

Consider the role the U.S. financial system plays in the global economy. It issues a large amount of dollar-denominated assets to a world craving reserve-currency assets. The figure below, taken from the U.S. Financial Accounts, shows liquid assets exported to foreigners was about $18 trillion at the end of 2019. These assets range from super-safe currency, treasury, and GSE securities to relatively safe repos, commercial paper, and corporate bonds.

As the main supplier of dollar assets to the world, the stability of the U.S. financial system is paramount to investors abroad. This crisis, though initially disruptive to financial activity, should ultimately serve to improve the stability of the U.S. financial system because it prompted the Fed to backstop almost all the major U.S. markets. The Fed also backstopped markets in 2008, but this time the support is much broader and includes repo markets, money markets, commercial paper, municipal securities, commercial mortgage-backed securities, and corporate bonds. The use and expansion of the Fed facilities to backstop markets sends another strong signal to foreign investors that the U.S. financial system will not fail. This will encourage them to hold more dollar-denominated assets issued in America. Put differently, the biggest kid on the financial block just got stronger.

To be clear, the U.S. financial system is not the only producer of dollar-denominated assets. The Bank for International Settlements reports there are about $12 trillion of dollar-denominated securities issued outside the United States. The next figure shows that this source of dollar funding combined with those dollar assets issued from the U.S. financial system together total about 30 trillion of relatively liquid dollar assets outside the United States.

For the reasons outlined above, this number is likely to grow over the next decade and further impede any contender to the dollar as reserve currency of the world. It is hard to imagine any other currency scaling up in size enough to compete with the $30 trillion of relatively liquid dollar-denominated assets outside the United States. This dollar monopoly by itself creates self-reinforcing growth toward more dollar use since investors want to hold, all else being equal, assets denominated in the most liquid currency.

Economic Implications

These three developments — heightened risk aversion, Fed branch banking, and a stronger Fed backing of the U.S. financial system — should further increase global demand for dollar-denominated assets. Demand was already high for such assets prior to the COVID-19 crisis and explain why President Trump could run such large budget deficits in 2018-2019 without causing inflation or interest rates to rise. While forecasting is fraught with danger, this added demand is likely to persist and exceed the increased issuance of U.S. public debt and other dollar-denominated assets for some time. This understanding is consistent with what financial markets are now telling us.

The COVID-19 crisis, in short, has intensified an excess demand problem for the global medium of exchange. This has several implications for the U.S. economy. First, the dollar is likely to stay overvalued and spur ongoing U.S. trade deficits with the rest of the world. Second, the unmet demand for dollar-denominated assets will keep interest rates low and push the U.S. government toward more budget deficits. Finally, this phenomenon will probably create additional disinflationary pressures in the U.S. economy.

So, while there are reasons for concern over some of what the Fed is doing, we are far away from inflation rearing its ugly head again. Disinflation is a far more likely outcome over the next decade. Moreover, worrying about inflation now could prove harmful if it causes policymakers to take their focus off keeping the economy afloat while the public-health battle is being fought. We are in the midst of what is likely to be the deepest recession in U.S. history. This recession should be our main worry for now.