Hummel on Whether to Expect Higher Inflation
About a month ago, I called Jeff Hummel, a monetary economist and economics professor at San Jose State University, to ask him whether he thought there would be a substantial increase in inflation due to the substantial drop in real GDP with no drop in the money supply. MV = Py. M increases, y falls, and so P (the price level) must rise, assuming V is relatively constant. As you’ll see below, V has fallen, which means that maybe P doesn’t have to rise much.
I had a more-practical interest than usual. At the time I owed about $48K on my mortgage and the interest rate is fixed at 3.39% per annum. So, other than a few gold coins I own, my mortgage interest rate is my main hedge against inflation. Jeff didn’t have a complete answer. Then I read a post by George Selgin that made me relax about inflation. I decided that paying down about $5K of my principal on my mortgage was a good idea because the reality was that that $5K would simply sit in the bank earning very little interest and the interest would be taxed. Paying down the principal on a 3.39% mortgage, by contrast, would earn me an after-tax rate of almost 3.39%. The reason is that I no longer itemize for my federal taxes and so get no federal tax break on my mortgage interest. Why almost? Because I do get a state tax break. My state marginal tax rate is 9.3%, so the net of tax return from paying down my mortgage = 3.39 * (1 – 0.093) = 3.07%.
Over the last couple of months, several people have asked for my opinion about the prospects for future high inflation, given the Fed and Treasury responses to COVID-19. I was so busy teaching online that I had no time to look into this question. But now that my teaching semester has ended, I do have a few preliminary thoughts that I can pass along.
Normally a severe supply-side shock to the economy, as created by the government’s lockdown, would alone cause a spike in the price level. But by also inhibiting people from spending money, the lockdown has induced a decline in money’s velocity. By reducing aggregate demand, the fall in velocity tends to dampen the impact of the supply shock on the price level. To give one anecdotal example of this increased demand to hold money, David Henderson and I recently discussed how drastically our credit card bills have declined over the last two months. This is a point that George Selgin alluded to in this post: https://www.alt-m.org/2020/04/27/return-of-the-inflation-mongers/. The decline in M2 velocity is quite visible in the monetary statistics, but to what extent its impact on aggregate demand will be offset by future Fed policy is something I need to explore further.
One person who argues that Fed policy will not generate future inflation is David Beckworth, in this article for National Review: https://tinyurl.com/yau48eak. David makes some interesting arguments. The one I found most intriguing is his claim about dollars moving abroad. To the extent that dollars flow abroad, this also dampens inflation. If the dollars held abroad take the form of deposits, they do not show up in U.S. monetary statistics. But if they are in the form of currency, they do give an upward bias to U.S. monetary statistics, which have never made any distinction between Federal Reserve notes held domestically and those held abroad. The upward bias is most significant for the monetary base, a point David Henderson and I made in our 2008 article about Greenspan’s monetary policy. But currency in circulation is still 10 percent of M2, and a quick glance showed that its rate of growth increased at about the same time as M2’s rate of growth increased. How much of that increase in currency represents foreign holdings is worth investigating, although it may be hard to determine.
May 26 2020 at 12:24pm
How odd to speculate about this w/o explicit consideration of Fed policy.
Of course the Fed ought to increase inflation in response to a supply shock, but so far it has not done so and market expectations of Fed policy (the Treasury Inflation Protected Security, TIPS, break-even rate) are for inflation over the next 5 years to be less than 1% p.a. If you are expecting inflation to be higher than that, you should take your savings and buy a TIPS.
May 26 2020 at 1:10pm
That would indeed be odd. Fortunately, Jeff doesn’t do what you say he does. He wrote, above, “The decline in M2 velocity is quite visible in the monetary statistics, but to what extent its impact on aggregate demand will be offset by future Fed policy is something I need to explore further.” So he admits that one needs to consider Fed policy. Unfortunately, neither you nor he has a crystal ball.
I don’t see how that follows at all. My current after-tax rate of return from paying down my mortgage is, as I wrote above, 3.07%. So the rate of return I would need from bonds is 3.07 divided by (1 – 0.22 – 0.093) = 3.07 divided by 0.687 = 4.47%. [My marginal federal tax rate is 22 percent.] Are you saying that if the inflation rate is higher than 1%, say 2%, the return I would earn on a TIPS is 4.47% or more? If so, I think you’re incorrect.
May 26 2020 at 5:31pm
You are entirely right about a modest increase in inflation.
May 26 2020 at 7:23pm
May 26 2020 at 3:42pm
When the Fed issues a dollar, it gets a dollar’s worth of new assets to back that dollar. So as long as the Fed’s assets keep pace with its money-issue, there will be no inflation.
May 26 2020 at 5:14pm
“I had a more-practical interest than usual. At the time I owed about $48K on my mortgage and the interest rate is fixed at 3.39% per annum.”
David – this is not terribly informative. What is important is the the % of monthly payment that goes to interest vs. principal. You could be living in $million mansion and in the last several months of you payment schedule where it is mostly principal you are paying off. I went through the same calculation maybe 15 years ago and decided to pay the mortgage off as there was very little tax savings to be realized on the interest deduction.
Of course times are different right now and certainly in Maryland, were I in a similar position, there would be virtually no tax advantage at all. But this all has to be weighed in terms of whether one is able to pay the mortgage off in a lump sum or not. Everyone is going to be in a different position financially.
With respect to the central question of the post, I can’t see any inflation on the horizon for 2-3 years minimum. It’s going to take that long to recover and certainly the indicators I’m following point to an ugly recovery that really won’t begin until mid-2021.
May 26 2020 at 7:23pm
It’s not as informative as you might like, but it’s informative enough to help me make the decision. It’s a “think on the margin” thing. Whether I have 1 year left on the mortgage or 4 (it’s closer to the latter), paying down $5K in principal gets me a 3.07% after-tax rate of return.
May 27 2020 at 9:36am
Understood. You are also fortunate to live in where the climate is moderate. We realized a significant rate of return by replacing all of our windows and doors. Our cumulative energy bill dropped by just over 20% year over year. At the time we did most of the work, there was a good tax rebate as well.
May 27 2020 at 12:31pm
Alan, I made a similar calculation and paid off our mortgage as there was little tax advantage in Georgia.
May 26 2020 at 7:43pm
I assume that Mr. Henderson has already maxed out all of his tax advantaged savings accounts. Otherwise paying down mortgage interest makes little sense. And also that his home is already well insulated, though so long as he isn’t living in a mansion, it probably wouldn’t take USD 5k to upgrade the insulation.
May 27 2020 at 9:49am
No. And there’s a good reason. My accountant, with whom I had to deal with electronically rather than in person for the first time ever, called me to ask why I put so little into my SEP-IRA ($3K versus the usual $10K to $15K.) I answered that it’s because I wanted to put in just enough to bring our marginal tax rate down from 24% to 22%. My view is, and everything that’s happened in the last 2 months has only strengthened it, that my marginal tax rate will never be below 22% and is likely to be higher. So putting a lot into a SEP-IRA is “reverse arbitrage.”
May 26 2020 at 9:17pm
I think we will contimue to see very low inflation, around 1%, and ocassionally periofs of deflation for these readons: https://finance.townhall.com/columnists/rogermckinney/2020/05/08/are-we-headed-for-inflation-deflation-or-stagnation-n2568448
May 27 2020 at 8:51am
Your 3.07% is also nearly* guaranteed, while your alternatives have some uncertainties such as future inflation. (*It’s unlikely but not inconceivable that tax laws may change, affecting your return).
May 27 2020 at 1:39pm
Expecting higher inflation; M2, cash, checking and near money, velocity declined from 2.2 in 2004 to 1.5 in 2014. A little context. Excess reserves ballooned from 1.9 billion in 2008 to 2.6 trillion in 2015. The Fed payed a 25 BPS spiff on reserves. Lending was done to only the most creditworthy counter parties. As crises abate, risk premia falls and velocity should increase. What does this mean for fiscal policy? John Cochrane’s work suggests fiscal policy drives inflation. A low discount rate is a higher real value which means lower inflation. Two year treasury yields averaged .66% from 2009 to 2016. Standard deviation was about .31%. Current two year rates are .18%. Less than a third. Unless rates rally substantially, It’s hard to imagine price level inflation near term. Of course I could be wrong.
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