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Low Inflation Is No “Mystery”

September 27, 2017

When is a mystery not a mystery? When Janet Yellen is puzzling over a lack of inflation, that’s when. So say Brian Wesbury, chief economist, and Robert Stein, deputy chief economist of First Trust, in today’s Outside the Box. The bottom line: QE didn’t work, and Janet knew it was unlikely to work, from the start.

So where did all that easy money go? I think I’ll let the authors tell you. I think you’ll enjoy this brief, clear-headed essay.

The essay was sent to me along with a rant by my friend Tom Bentley. One of his paragraphs really rang a bell with me:

Here’s the real problem: “The Fed has never fracked a well or written an app. We understand that government bureaucracies want to take credit for everything.” They simply refuse to understand that government in a healthy economy must serve the needs of private endeavor, not the other way around. As taxes at all levels exceed 37% of GDP in the US, and over 50% in Europe, there should be no doubt why advanced country growth is lower than it has been since we’ve had advanced countries. Government typically makes a negative contribution to productivity – look at how much we have expanded employment in education (mostly by hiring more administrators), while educational outcomes have stagnated. The real travesty is, “[The Fed] is teaching an entire generation of young people, who in many cases don’t study economic history, that growth requires government intervention.” Helps explain why so many millennials are Socialists, victims of the massive indoctrination campaign conducted by the Democrat party. 

I am in Chicago today, and after spending a delightful 30 minutes with Rick Santelli to do a three-minute television hit on CNBC (you can see it here), I found out my lunch plans had changed; so I called bond guru Jim Bianco, who met me for lunch and then played Chamber of Commerce host, taking me all over North Chicago for 45 minutes and showing me all these wonderful spots where the mob congregated and shot each other, plus Wrigley Field and all sorts of other good history.

Jim and I agreed that no matter what Yellen says – and no matter what the Fed dot plot says – they are not going to raise rates five times between now and the end of 2018. And whatever quantitative tightening they do actually undertake is going to be very timid and slow. The simple fact is that the current FOMC wants to walk away maintaining they were doing the right thing and bragging that all of the good results we’ve seen, as weak as they are, are things they can take credit far and that the problems are somebody else’s fault. Pretty much the way every teenager and certainly every politician likes to operate.

But it’s a beautiful day here in Chicago. I’ll meet my host tonight and then speak to the Wisconsin University real estate program alumni tomorrow morning before flying back to Dallas and then on to Portugal. Between now and this evening I have a few more meetings, so I’m going to hit the send button and let you dig into today’s Outside the Box. Enjoy your week!

Your believing the government is the problem, not the solution analyst,

John Mauldin, Editor
Outside the Box

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Low Inflation Is No “Mystery”

By Brian S. Wesbury, chief economist, and Robert Stein, deputy chief economist, First Trust
September 25, 2017

Last week, at her press conference, Federal Reserve Chair Janet Yellen said continued low inflation was a “mystery.”

She’s referring to Quantitative Easing (QE) and the lack of the economic evidence that it worked. The Fed bought $3.5 trillion of bonds with money it created out of thin air in an extraordinary “experiment” to avoid repeating the mistakes of the deflationary Great Depression. Milton Friedman was the leading scholar in this arena, proving the damage done by a shrinking money supply during the 1930s.

The money supply is a “demand-side” economic tool. A lack of money inhibits demand, while a surplus of money (more than the economy needs to grow) can cause inflation. The idea of QE (which has been tried unfruitfully for more than a decade in Japan) was to boost “demand-side” growth. And, yet, inflation and economic growth have both been weak. In other words, demand did not accelerate.

So forgive us for asking, but after unprecedented expansion of banking reserves and the Fed balance sheet, with little inflation, is it really a “mystery?” Or, is it proof of what we believed all along: QE didn’t work?

We get it. Just the fact that the US economic recovery started in 2009 and stock prices went higher is all some need to convince themselves that QE worked. But no one knows what would have happened without QE.

Back in 2008, even Janet Yellen knew there were problems with QE. During a December 2008 Fed meeting, she said there were “no discernible economic effects” from Japanese QE. Back then she was a Fed Governor and this was said during internal debates about whether to do QE. Today she leads the Fed and bureaucracies can never admit failure. So, the lack of inflation becomes a “mystery.” 

Conventional Wisdom is so convinced that QE worked, it can’t see anything as a failure. QE supposedly pushed up stock prices and drove down interest rates, while at the same time boosting jobs.

As for the lack of demand-side growth, the explanations are confusing. Yellen says low inflation is a mystery, others say it’s because of new technologies, global trade, and rising productivity. Slow real GDP growth is blamed on global trade, a Great Stagnation in productivity and the lack of investment by private companies. QE gets credit for the things that went up, but things that didn’t are explained away, denied, or determined to be mysteries.

We have promoted an alternative narrative that agrees with the 2008 Janet Yellen – QE didn’t work. It flooded the banking system with cash. But instead of boosting Milton Friedman’s key money number (M2), the excess monetary base growth went into “excess reserves” – money the banks hold as deposits, but don’t lend out. Money in the warehouse (or in this case, credits on a computer) doesn’t boost demand! This is why real GDP and inflation (nominal GDP) never accelerated in line with monetary base growth.

The Fed boosted bank reserves, but the banks never lent out and multiplied it like they had in previous decades. In fact, the M2 money supply (bank deposits) grew at roughly 6% since 2008, which is the same rate it grew in the second half of the 1990s. 

So, why did stock prices rise and unemployment fall? Our answer: Once changes to mark-to-market accounting brought the Panic of 2008 to an end, which was five months after QE started, entrepreneurial activity accelerated. New technology (fracking, the cloud, Smartphones, Apps, the Genome, and 3-D printing) boosted efficiency and productivity in the private sector. In fact, if we look back we are astounded by the new technologies that have come of age in just the past decade. These new technologies boosted corporate profits and stock prices and, yes, the economy grew too.

The one thing that did change from the 1990s was the size of the government. Tax rates, regulation and redistribution all went up significantly. This weighed on the economy and real GDP growth never got back to 3.5% to 4%.

Occam’s Razor – a theory about problem solving – says, when there are competing hypothesis, the one with the “fewest assumptions” is most likely the correct one.

The Fed narrative assumes QE worked and then uses questionable economics to explain away anything that does not fit that theory. It blames “mysterious” forces, both strong and weak productivity and claims business under-invested. We’ve never understood the weak investment argument; why would business leave opportunities on the table by not investing?

Our narrative is far simpler. It looks at M2 growth, gives credit to entrepreneurs, and blames big government. After all, the US economy grew rapidly before 1913 when there was no Fed, and during the 1980s and 90s, when Volcker and Greenspan were not doing QE. And history shows that inventions boost growth, while big government and redistribution harm it. Because it has the fewest assumptions, Occam’s Razor suggests this is the more likely hypothesis.

The Fed has never fracked a well or written an app. We understand that government bureaucracies want to take credit for everything. But, in spite of record-setting money printing, inflation did not rise. Prices are measured in dollars, so if those dollars had actually entered the economy, prices in dollar terms would have gone up. They didn’t, which clearly says that money didn’t enter the economy and QE didn’t work as advertised.

Some say that’s because the money went into financial assets, but if that was the case the P-E ratio for the S&P 500 would be through the roof. But because earnings have risen so sharply, the P-E ratio is well within historical averages based on trailing 12-month earnings and relative to bond yields.

We also understand that entrepreneurship is a “mystery” to some people because they can’t do it. Most people can’t change the world the way entrepreneurs can, but that doesn’t mean that by rearranging the assets of an economy in a different way, entrepreneurs don’t create new wealth.

By claiming that low inflation is a “mystery” the Fed is admitting it doesn’t understand the mechanics of QE. Yet, it is perfectly willing to allow people to think QE is what saved the economy. This is teaching an entire generation of young people, who in many cases don’t study economic history, that growth requires government intervention. The only “mystery” is why they would allow this to happen.

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Gary Black

Sep. 29, 2017, 9:49 p.m.

It is rare that there is an OTB article which is disappointing, as this one is.  First, a rant from Tom Bentley (we have taxes, therefore it is obvious to all but the stupid why our growth is low) and then a one-sided diatribe by a pair of apparent Fed-haters who make a series of broad, sweeping statements with no supporting facts or analysis;  merely their bold assertions which, I suppose, we are meant to be blessed by.

jack goldman

Sep. 29, 2017, 12:52 p.m.

ETF’s are a fraud. Stocks are a fraud, the “economy” is a fraud, because the underlying measurement in counterfeit currency dollars is a fraud. In real US silver dollars the Dow index was about 1,000 silver dollars in 1966 and is about 1,000 real US silver dollars fifty years later. Counterfeit currency is a massive Federal Reserve felony fraud. Owners of stocks, bonds, ETF’s, real estate (disclosure I made a small fortune in real estate) are only winning because counterfeit currency is fraudulently counterfeited by Wall Street at the NY Federal Reserve Bank. The US Fed is not American, not Federal, not a bank, and has no reserves. The Fed is a secret European owned counterfeiting cartel selling unborn American children into debt slavery. The dollars are debt notes being counterfeited to promote higher fees and taxes. US debt is now $20 TRILLION? Government and banks took over America because of felony fraud counterfeiting of debt. Debt is counterfeited. There will be a reset. Stocks owners and underlying ETF’s will be unsecured creditors in a bankruptcy proceeding, getting NOTHING. Think of the hundreds of major corporations that have gone bankrupt from Northwest Airlines to Lehman. Wall Street counterfeits currency to pick winners and losers. Facebook, Amazon, Netflix, and Google are FAKE businesses, making nothing, doing nothing. Soon, Wall Street will pick America and American investors to be the losers the same way Nathan Rothschild did after Wellington defeated Napolean. It’s not if, but when. Nobody cares. Elites are bought off with “felony fraud inflation” manufactured by the Fed. Protect yourself. No one else can or will.


Sep. 28, 2017, 12:13 p.m.

In my humble opinion, Q.E. replaced trillions of dollars lost due to the bursting of the U.S. housing market. Without Q.E. banks didn’t have very much capital to loan out. Plus, they were afraid to even make loans. Add a stronger U.S. dollar and the collapse of commodity prices, especially oil and we got deflationary pressures. No real mystery to the lack of inflation.

Barry Rose

Sep. 28, 2017, Noon

Scenario 1: Fed creates $3.5 Trillion out of thin air, buys bonds, treasuries & mortgage backed securities from banks. Bernanke agrees to pay banks 1.25% not only on required reserves but on excess reserves. Reserves quickly swell from about $500 bil to over $2.5 tril. Banks slow their lending, make billions in guaranteed interest payments, loan cheaply to the wealthy.  Velocity of money keeps slowing; no inflation.
Scenario 2: Fed creates $3.5 tril out of thin air. They calculate that there are approv. 126 mil households in the US, and allow a one-time $27,000 deduction per household on their federal tax return. Loads of refund checks hit, money is spent on cars, furniture, etc. and the velocity of money goes through the roof. 
Janet - which one benefits the economy AND increases inflation? 2 guesses….

Steve Pelletier

Sep. 28, 2017, 11:55 a.m.

Wikipedia gives slightly different GDP tax rates, with the US at 33.4% and the EU at 35.7%. Not that it makes a difference to the argument



Sep. 28, 2017, 2:02 a.m.

Alan Francis

Perhaps governments cannot have the truth exposed. With QE and increased debts governments cannot afford inflation as this will inevitably result in increasing interest rates. This in turn will complicate governments dilemma of servicing their debt, which even in the current ZIRP they are incapable of doing. I don’t foresee inflation or rising interest rates just look to Japan.


Sep. 27, 2017, 9:15 p.m.

This article was a series of unsupported assertions. No figures, no graphs, no statistics, just assertions. I think many of these assertions are false news. Taxation in the US did not rise significantly since the 90’s, much less since the great recession. P/E ratios are very high, as Mauldin has frequently pointed out in the recent past. And they are high relative to bond yields. Nor has employment in education ballooned since the recession, as Tom Bentley suggests. I laugh at his conspiracy theory that “so many millennials are Socialists, victims of the massive indoctrination campaign conducted by the Democrat party”. Nonsense.

I’m used to better from you, Mauldin.


Sep. 27, 2017, 7:52 p.m.

Wages right now are really sticky. Meanwhile prices are rising, despite what the new inflation gauges say. We came out of a hard recession in 2008 and the employers are fighting like crazy to not let pay rise. Once wages increase, demand will grow and inflation will increase. When this happens normalcy will be restored. It takes a decade maybe more for all of these things to come about. If Donald Trump follows through on his promise, this may be sooner than later. But that’s a big IF.

Rolf H Parta

Sep. 27, 2017, 7:48 p.m.

@Willis—higher reserves of cash on deposit at the Fed [which is why the monetary base can go up hugely and the M<2 money supply hardly change] do NOT help the banks “pass stress tests”.  Reducing exposure to risk [loans, “deals”, and market making are risk] and increasing equity are what help do that.

The way I see it, the original Bush support for the banks was to assure that they could open every day—so that workers’ paychecks would continue to be good.  QE, which came afterward, wasn’t about that ... it was a blatant attempt to hit the monetary gas pedal while [at the same time] Congress was refusing to substantially increase spending, or permanently cut taxes, and the banking regulators were telling the banks [frantically in some cases] to REDUCE risk [including loans].

Having, some years ago, worked at high levels in the banking industry and having dealt with their regulators, I can assure you that, while both groups are well meaning, they are far behind where you’d think they should be in dealing with risk.  [Most don’t even have a good, clear understanding of what the risks they’re dealing with are.]

Sadly, the ordinary public is even more poorly educated about risk.

Andrew A. Paterson

Sep. 27, 2017, 4:44 p.m.

My son and I attended her “speech” in Ann Arbor this past spring. She did not instill confidence. She cherry picked “good” things and did not address any other possibilities. Nor did the faculty allow the Q & A to go there - they chose the audience questions that were designed to stroke her personal achievements (to inspire the snowflakes, I presume).
Basically, she acted like most politicians: lack of candor, refusal to discuss the not so nice possibilities, and therefore sounding isolated. From the ivory tower indeed.

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