Tuesday, April 5, 2011

San Francisco Fed: Money Printing Causes Prices to Drop

Two economists at the Federal Reserve Bank of San Francisco, Reuven Glick and Sylvain Leduc have just reached the conclusion that Fed money printing doesn't cause price inflation. In fact they go one better, they claim that Federal Reserve asset purchases (which create money out of thin air) are deflationary.  I am not making this up. Here's the introduction to their argument:
Prices of commodities including metals, energy, and food have been rising at double-digit rates in recent months. Some critics argue that Federal Reserve purchases of long-term assets are fueling this rise by maintaining an excessively expansionary monetary stance. However, daily data indicate that Federal Reserve announcements of large-scale asset purchases tended to lower commodity prices even as long-term interest rates and the value of the dollar declined.
What makes them so sure about this price deflation? They start off by telling us this:
...commodity prices have surged since Chairman Bernanke’s Jackson Hole speech. The Goldman Sachs Commodity Index, a heavily traded broad index of spot commodity prices, rose 35% between the Jackson Hole speech and the end of February. The increase was widespread, spanning a range of commodity categories. Industrial metals rose nearly 30%, energy prices climbed 35%, and food prices rose close to 50% during the six-month period.
So how with these facts do they reach their conclusion. They argue this way:
The LSAP [Large Scale Asset Purchases] announcements about monetary policy may have signaled that the Fed perceived economic conditions to be weaker than previously thought. Alternatively, they may have increased market worries about risk and made Treasury securities more desirable as safe-haven investments. Thus, an announcement that makes investors feel that conditions are worse than originally perceived or that heightens risk concerns may lead investors to increase their demand for Treasuries, lowering their yields. These concerns also could reduce investor demand for other assets, such as commodities, resulting in lower prices.
They then go on to report on an absurd empirical study that they completed. There are methodological problems with empirical studies in the first place in the social sciences, but this study is over the top in its poor structure. Their study consisted of studying the effects of Fed announcements of future LSAP activities by comparing closing market prices on the days of the announcements with closing prices on the previous days for commodities, the 10-year Treasury note, and the yen value of the dollar. The results of their study:
During the first round of LSAPs, the value of industrial commodities fell on average 0.9% and energy 3% on announcement days. By contrast, during the second round of LSAPs, commodity prices also fell, though only by a marginal amount.
From this, they reach this conclusion:
Our analysis does not provide evidence that Federal Reserve large-scale asset purchases fueled the rise in commodity prices. It shows that, despite the fall in long-term interest rates and the depreciation of the dollar, commodity prices fell on average on days of LSAP announcements. The effects were more pronounced during the first round of LSAPs. The results may have occurred because the LSAP announcements heightened investor concerns about risk or led them to revise downward their growth expectations. Thus, other factors, such as growth in emerging market economies, are more likely to be the main drivers behind the recent rise in commodity prices.
What they are doing here is assuming the only impact that LSAP has on the market is the impact that occurs on the day of the announcement. There is no basis for this.

There could be many reasons for a decline on the day of an announcement, starting with the real simple fact that many traders buy on the rumor and sell on the news. A better structured study (and again I have problems with all these empirical studies, but this one is so naively structured that I am forced to comment) would be one that looks at commodity prices from the start of rumors and anticipation that the Fed might be expanding its money printing until the day of an actual announcement.

 But, if we even grant their premise that the initial psychological impact will be to push commodity prices lower, this says nothing about what the impact of the actual money printing will do to prices over the longer term.

The jump from what happens the day of an announcement, that might have been fueled by anticipation of such an announcement certainly says nothing, I mean completely zero, about what will happen once the Fed starts purchasing assets and the money enters the system. And I must add the sloppy structuring of their premise and conclusion provides them somewhat of an escape hatch when you look at their wording, since whenever they specifically state commodity prices are headed down, they are always sure to state they are referring to what happens the day of an announcement. But in their conclusions, they expand beyond the daily qualifier to suggest that commodity price movements over time (not just for the day of an announcement) are not pushed higher because of LSAT activities. Their concluding sentence points to the broad conclusions they reach from the study of price activity only on days of announcements:
Thus, other factors, such as growth in emerging market economies, are more likely to be the main drivers behind the recent rise in commodity prices.
Just what makes Glick and Leduc think that the entire Fed impact on commodity prices begins and ends with the announcement of such by the Federal Reserve? In fact, if one looks at what happens over a longer period, which gives the money the Fed actually prints to work its way into the system, you might find that as Glick and Leduc tells us that:
...commodity prices have surged since Chairman Bernanke’s Jackson Hole speech. The Goldman Sachs Commodity Index, a heavily traded broad index of spot commodity prices, rose 35% between the Jackson Hole speech and the end of February. The increase was widespread, spanning a range of commodity categories. Industrial metals rose nearly 30%, energy prices climbed 35%, and food prices rose close to 50% during the six-month period.


  1. Mr. Wenzel:

    Can we have severe price inflation without wage inflation?

  2. Sure, if all the new money goes to elitists first, they bid up the prices and the rest of us spend time trying to play catch up.

  3. Exactly. There has been no wage inflation for the past few years. Go to the grocery store and tell me if prices have remained the same during the same period.

    And don't give me the stupid Ipad argument.

    The thought that the Fed QE results in deflation is completely and totally asinine.

  4. These fools could have made better use of their time, by heading down to their local book store or library and grabbing a book on American History. They could then go back to the founding of our nation and research what precipitated the term "not worth a Continental". From there they could move on to the disastrous First and Second banks of the US. If this were not enough for them, they could move on to world history and find thousands of examples of what happens when a fiat money rapidly expands. In fact if they read enough world history they would soon realize that all fiat money systems eventually collapse for the same reason. Its not as though one needs a degree in economics to understand this.

  5. Bob,

    In this case I think they are at least partly right. The Fed, with all the quantitative easing want inflation to happen and they want to avoid deflation at all costs. Alas, in reality that won't happen because the money they inject into the system will push the bid on the assets that will give the traders risk-free profits. This is in the bond market.

    Primary dealers front-run the Fed, buy the Treasuries at a lower price and flip the bonds back to the Fed and thus capturing risk-free profits. So even though there are signals from commodity and PM markets that inflation is coming, the money is not finding its way up-hill at the moment. So if and when QE stops, commodities and PM's will fall.

  6. I blame the arbs. On the announcement days, treasury yields have fallen and people step in to buy and sell other securities based on the relationships between those securities and treasury yields. For instance, if equity returns and treasury yields have a positive correlation and equity returns and commodity returns have a positive correlation, then a decline in treasury yields would create opportunities for stat arb bots to take bets on the stocks and commodities.

  7. You can't argue with these people...just buy physical PM every pay period.

  8. Thanks for this. Just when I think people could start taking California seriously, I find even our PhD economists are dumb.

  9. There may not be that much wrong with the direct observation (though I agree with the methodology criticism).
    These observations can be correct in the very short term. What they see is not deflation, but a localized shift in price levels from one sector to another, caused by the announcement. It is obviously fleeting at best.

    As if ONE sector in a rising demand (or decl. supply) situation can not have rising price level during a deflationary period, or as if a sector in declining demand (or rising supply) can not have a declining price level. They don't get that.

    They would never even consider that in a completely stable money (supply) situation, the natural order of growing productivity is to foster a declining price level.
    When they perceive it, they see anathema.

    The proper analogy for these highly paid academes, is that of throwing a large boulder into the sea during the incoming tide:
    The bolder does depress the water level around it to a limited extend, while all the same the level of the sea is rising.

    These guys don't see the distinction

  10. Regardless of the nonsense stated by FED economists, the present rise in commodity prices is NOT caused by the PRESENT insane expansion of the money supply. This will cause prices to rise in the not too distant future.

    The present rise in prices is caused by PAST FED expansion of the money supply. The FED has been issuing enormous amounts of legally counterfeited money ever since it began operation in 1914. Since the end of WWII, Americans have been borrowing (increasing debt) and spending that money for cheap foreign commodities produced by essentially slave labor (mostly Japanese and Chinese). But foreigners have not been buying the more expensive American commodities and have held these dollars as a hedge against their own countries' depreciating currency. In addition to that, the dollar is the international reserve currency and practically all foreign exchange was denominated in dollars. This kept these excess dollars from circulating in the U.S. and driving prices up -- until now.

    There's over $7 trillion dollars in foreign hands due to the trade deficit alone and this doesn't include U.S. aid to foreign countries (including China), bank loans to third world counties, etc. In other words, there's an enormous amount of dollars in foreign hands. Foreigners see Bernanke creating mountains of new money which will drive prices up in the U.S. The dollars they hold are losing value and they want to get something for them before they lose any more. Thus they are bringing them back to our shores in demand for commodities, real estate, etc.

    While foreigners are divesting themselves of the dollar, the FED, in collusion with Congress, is flooding the economy with additional dollars. As prices rise precipitously in the near future, U.S. citizens, who are now trying to save, will be forced to spend their dollars or see them lose value. Thus we have foreigners removing commodities and dumping dollars -- this leaves less commodities for Americans and more dollars with which to buy fewer commodities -- of course prices rise. At the same time, the FED and Congress is flooding the economy with more dollars and in the near future Americans will be forced to spend their savings or watch them lose value.

    These three factors will eventually lead to hyperinflation and social disintegration.

    Again, it's PAST expansion of the money supply that's driving prices up today. The present expansion will cause them to rise even faster in the near future.

    Bill Denman