The inflationary set-up: 2020 is not a case of déjà vu 

Peter Warburton - 18 May 2020

If the large-scale asset purchases (QE) undertaken by the US Federal Reserve in 2009-13 failed to propel the US economy in an inflationary direction, why should we expect a different outcome today?  Isn’t this the definition of insanity? In refuting this charge, it is necessary to understand more clearly why the central bank interventions provoked by the GFC did not foster an inflationary environment. Essentially, the GFC was a car crash in which the vehicle’s dimensions were compressed. Think of the Fed as the driver’s airbag and the government as the emergency services attending the scene. 

The actions of the authorities mitigated the severity of the credit crunch, as shown in figure 1, but did not prevent a contraction in the real value of domestic debt. Not until 2014 did the US truly recover from the impact of the credit accident. While the expansion of the Fed’s ownership of debt and loan assets from $741bn at end-2007 to $4599bn at end-2014 and of the federal government’s asset ownership from $301bn at end-2007 to $1160bn at end-2014 were dramatic responses, they supplied replacement, not additional, balance sheet capacity to the domestic financial system.

Figure 2 shows the balance sheets that were compressed so violently in 2008. For the purposes of this summary exercise, we combine US-chartered banks, foreign banking offices in US, banks in US-affiliated areas and credit unions into the category “bank and CU”. And we group money market mutual funds, government-sponsored enterprises and federally-related mortgage pools, issuers of asset-backed securities, finance companies and security brokers and dealers into our shadow banking composite. Banks’ experience of the credit crunch was comparatively brief, but shadow banks suffered a near-death experience as the scope for securitisations evaporated. Again, 2014 was the first year of confident expansion of both banks and shadow banks after the crisis.
Furthermore, alongside the reflationary actions of the Fed and the US government, there were regulatory actions undertaken by the US Congress and, internationally, by the Bank for International Settlements (Basel 3) that hindered the ability of the private credit system to intermediate the cheap credit apparently on offer to domestic households and businesses.  The US credit system was like a vehicle on a test ramp at the garage, its gas pedal was pressed hard down, the engine was revving, the wheels were spinning but the car was going nowhere.

Fast forward to 2020, and we observe an acceleration of bank credit, no implosion of shadow banks, and interventions on an even greater scale by the US federal government and Federal Reserve. Outrageously, share buybacks have erupted since the Fed stepped in to absorb vast quantities of US Treasury bonds in March, stimulating demand for corporate bonds in the process. US authorities have taken unprecedented actions to shore up the nominal purchasing power of US credit assets. By next year, we may find that a significant tranche of corporate credit has failed, including loan facilities extended in the context of business lockdowns due to Covid-19. However, the near-term impact of “shock and awe” interventions in the US economy and credit markets is to fuel inflationary impulses. Having 20-20 vision of 2008-13 reveals that 2020 is not a case of déjà vu.

Figure 1: 

Data source: US Federal Reserve Z1 Financial Accounts

Figure 2: 

Data source: US Federal Reserve Z1 Financial Accounts

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