Quantity Theory of Money
Cayman Islands’ monetary policy is determined in Washington, DC. Cayman’s currency, the KY dollar, has a fixed exchange rate with the US dollar of US$1.20 per KYD and is supplied or redeemed by the Cayman Islands Monetary Authority at that rate in response to market demand.
The Cayman dollar is more than fully backed with the equivalent value of US dollar reserves, which guarantees the integrity of that exchange rate. Furthermore, trade in goods and services and capital flow freely between Cayman and the US, and the rest of the world. Together these features of Cayman’s monetary system tightly link the behaviour of prices and interest rates in Cayman to those in the United States. Thus what happens in the US, in terms of inflation and interest rates, must happen approximately in Cayman.
As any Caymanian will tell you, however, prices in Cayman, especially of goods, are almost always higher than in the US. Most goods are produced abroad and imported. They face import duties and transportation costs. Retail distribution in Cayman may not be as efficient or competitive as in the US, adding further to the price paid by Caymanians. But there are limits to this spread because Caymanian’s are free to buy on the Internet or while travelling abroad, and they do so in large numbers.
Higher prices in Cayman do not mean higher inflation, the rate of increase in prices over time, in Cayman unless the spread between prices in Cayman and the US is increasing over time. While inflation in Cayman must be close to that of the US over time, its behaviour over short periods can differ significantly. If we remove the effect of Hurricane Ivan on the Cayman inflation rate by assigning Cayman with the same rate in 2005 as in the US, the inflation rates in the two countries averaged 2.5 per cent in the US and 2.6 per cent in Cayman between 2000 and 2008. Without that adjustment this nine-year average was 2.9 per cent in Cayman. But the averages in 2005, the first full year after Ivan, were 4.0 per cent in the US and 7.3 per cent in Cayman. Cayman experienced much higher inflation following Ivan, because Ivan reduced the available supplies of goods and services and it took some time and extra expense to replace and rebuild them. In 2006 inflation averaged 2.1 per cent in the US and 0.8 per cent in Cayman.
Even without tariffs, transportation costs and inefficiencies, Cayman’s inflation rate and interest rates might not exactly match those in the US for several reasons. Inflation in the US and in Cayman is measured by the rates of change in consumer price indexes (CPI). As the average consumption basket of a typical Caymanian is different than that of a typical American, the items in the CPIs of each are different. As the relative prices of different goods change in response to consumer tastes and production costs, (supply and demand), inflation rates in the US and Cayman can differ modestly even if each and every individual good’s prices are the same and change at the same rate.
A similar proposition applies to interest rates. Borrowing rates between different people and companies within the US vary because of differences in their credit risks and costs associated with underwriting. The same factors affect Caymanian borrowers. However, the basic rate charged to an AAA credit rated company in Cayman cannot be much different than for a comparably creditworthy borrower in the US because, for some Caymanians at least, the borrower is free to borrow from either place. Similarly those with funds to invest are free to invest in Cayman or abroad and will choose the investments with the best expected risk-adjusted return.
Beyond such considerations, which would apply to individuals within the US relative to others within the US as well, Cayman inflation and interest rates are necessarily dominated and driven by the behaviour of inflation and interest rates, i.e. monetary policy, in the United States. So what can we expect from the US?
The causes of inflation
In reaction to the financial and credit crisis that seized American and international financial markets in September 2008, the Federal Reserve has pumped enormous quantities of credit into the market in an effort to unblock clogged credit flows. The Fed creates this credit out of thin air, or as Fed Chairman Bernanke put it, it is printing money. Knowing that inflation is ultimately the result of the central bank – the Federal Reserve – printing too much money, many people are concerned that the Federal Reserve’s recent and current policies doom the US and the dollar to serious inflation in the next few years. This section reviews the historical relationship between the growth in the money supply and prices (inflation) and the recent behaviour of the money supply, and presents my assessment of the prospects for inflation in the US over the next few years.
In the long run inflation reflects the rate of growth of the money supply. Inflation one to two years in the future will approximately equal the current growth rate of broad money less the rate of growth of potential GDP. Both theory and evidence say that the money supply has no long run effect on real GDP output, thus ultimately the entire long-run effect of money growth is on the CPI price level.
In the short run other factors can dominate the behaviour of inflation. In the long run a reduction in the economy’s potential growth rate increases the inflation rate resulting from a given rate of growth of the money supply. However, in the short run if real income growth slows or even falls, with no change in its long-run potential growth rate, it has the opposite effect on inflation. Economists refer to the difference between actual and potential real output as the output gap. When actual output falls below its potential, as occurs during recessions, inflation is reduced for a given rate of growth in the money supply – the demand for money increases temporarily.
The US central bank – the system of Federal Reserve Banks – indirectly controls the money supply, currency held by the public and the public’s deposits with banks, and its rate of growth. There is a link between the money created by the Fed, called base money, and the broader money supply (M). The two are related by the so called the ‘money multiplier’. Usually the money supply grows at about the same rate as base money, because the multiplier is constant or only changes slowly.
The Fed’s balance sheet
With these ideas in mind the huge injection of liquidity by the Fed is worrying many people. The Fed has increased base money as a result of large loans to banks and other financial institutions and as the result of buying government securities, mortgage-backed securities and other assets from the market. By two measures the increase has been huge. Total Federal Reserve Credit has more than doubled over the last year from 0.90 trillion dollars on 11 April 2008 to US$2.15tr on 15 April this year. Almost all of that increase occurred since September. As a result, base money doubled over the same period, rising from US$874bn on 10 September 2008 to US$1,819bn on 22 April of this year.
The Federal Reserve argues that this will not cause inflation for two reasons. First, the large increase in the provision of Federal Reserve credit and base money was undertaken because of a large increase in the demand for liquidity by banks and other financial institutions in response to the subprime mortgage crisis. Thus doubling base money has not increased the money supply by nearly as much. Using a popular, relatively broad definition of money (MZM)3, the money supply rose from US$8.6tr on 7 April 2008 to US$9.4tr on 6 April 6 20094. Stated in terms of growth rates, which can be directly related to inflation rates, the year-on-year growth in MZM over the past year was 9.7 per cent. This is already significantly reduced from the year-on-year increase of 14.5 per cent on 19 January of this year and only modestly above the 8.7 per cent average annual rate of growth over the decade ending December 2008, during which inflation averaged 3.0 per cent. The demand for money, k, grew about 2 per cent per year on average over this period.
Secondly, the Fed estimates that over the past year the public’s demand for money has increased temporarily as the public ‘moved to safety’ in the holding of its assets, in terms of currency and insured bank deposits. An increase in money demand (k) or equivalently a decrease in its velocity of circulation (V) means that the supply of money can grow more rapidly to that extent without increasing inflation. In addition, the recession with its increasing ‘output gap’ further reduces inflation temporarily.
Finally, the Fed intends to withdraw the extra liquidity it has injected, and thus reduce base money, as the credit crunch eases and the economy begins to recover. It remains committed to its target for inflation of around 2 per cent. Thus the answer to the question of whether Fed policy will produce inflation in a year or two depends primarily on whether it successfully withdraws the large amounts of liquidity injected over the past six months. I have confidence that it will be able to do so more or less, but not exactly, at the right time and pace as the economic activity recovers.
The real risk of inflation, however, is political. The Federal budget has unfunded liabilities – the difference between the cost of the benefits promised and the revenue now legislated to pay for them – that simply cannot be paid for. The Federal budget deficit expected over the next three or four years as a result of the financial crisis, recession and foreign wars of several trillion dollars is nothing compared to the present value of the government’s unfunded obligations to pay out Social Security benefits of about 13 trillion dollars. The present value of unfunded liabilities of Medicare commitments is six times – yes six times – that amount. It is not possible to raise taxes enough to cover these commitments. Promised benefits will have to be cut. Invariably tax rates will be raised as well and the slowing of economic growth resulting from all this will make the burden of these deficits even harder to carry6. In addition, the rest of the world will not continue to finance as much of annual US deficits, and thus to own as much of the outstanding debt, as they have in the past, i.e. the market will force our external trade deficits to contract.
All of this adds up to higher, potentially significantly higher, interest rates in the years ahead ,once we have recovered from the current recession, to enable the government to raise the money needed to finance its revenue shortfalls. Just how high interest rates will raise will depend on how much government spending can be cut and future entitlement promises reduced, how efficient and productive the economy will be and thus how high its growth rate will be, and how large a trade deficit the rest of the world allows the US to have.
“Economists have found that structural deficits raise long-run interest rates, complicating the Fed’s dual mandate to develop a monetary policy that promotes sustainable, non-inflationary growth. The even more disturbing dark and dirty secret about deficits, especially when they careen out of control, is that they create political pressure on central bankers to adopt looser monetary policy down the road.7” The short-run effect of monetary growth is the opposition of its long run effect. Increasing the Fed’s creation of money initially pushes down interest rates as it buys more government securities or increases its lending to banks. However, as the higher money growth rate increases inflation, higher expected inflation gets built into new borrowing and lending interest rates pushing rates up eventually.
Current monetary policy in the US does not need to result in higher inflation down the road. But the higher interest rates the US is in for risk generating misguided political pressure on the Fed to try to keep them low. If the Federal Reserve gives in to that pressure, inflation will be higher and as soon as the economy comes to expect that higher inflation, nominal interest rates will end up being even higher still. The year-on-year inflation rate reached 14.6 per cent in March and April of 1980. It is unlikely that the US will experience such high rates over the next decade, though they could reach higher single-digit rates if the government does not rein in its programmed excesses. Whatever the outcome, Cayman will be obliged to tag along for the ride.