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 13 May 2009 
SERDAR KÜÇÜKAK
Ι
N +31 (0)20 629 5086 ECONOMICS DEPARTMENT
 
Special macro comment
Serdar Küçükak
ı
n, senior economist
Inflated fears
•
 
Inflation fears are somewhat overstated
•
 
Central banks have plenty exit strategiesWill the extraordinary expansion of central bank balancesheets lead to a serious bout of inflation? The short answer tothis question is most probably not. In this article we outline themain justifications for this view. Firstly we present a simpleframework to suggest that market participants should focus onexpectations rather than “real” factors in seeking to understandinflation risks in the coming years. In particular we examinehow inflation expectations could derail even if the realeconomy is in the doldrums. Secondly we show how tomanage the different variants of exit strategies.
The Phillips curve
To understand why current inflation risks are low, it is importantto look beyond slogans and take a broad look at the economicsof inflation. In the standard expectations-augmented Phillipscurve, inflation can arise because of two events: anoverheating economy or because inflation expectations losetheir anchor:
П
=
П
e + a x (Y – Yp)where
Π
is inflation,
Π
e is expected inflation and Y – Yp is theoutput gap (output minus the potential level of output).According to this theoretical framework, policy changes causeinflation either by stimulating spending, thereby pushing theGDP above its potential, or by causing the public to raise itsinflation expectations and thus raise prices in anticipation of inflation.
Output gap
If we return to reality, what does this mean for the futureinflation outlook? As the following diagram shows, the IMF’scalculations up to 2014 indicate that output gaps do not pose aserious inflation risk. The world output gap turned negative in2008, and so far this negative output gap has only got bigger,meaning that the difference between the potential output andthe real output is growing. In fact the IMF’s calculationssuggest deflation and not inflation, especially in 2010. Moreimportantly, the general expectation of a feeble recoveryaround the world implies that the global output gap will remainvery negative throughout 2010 and beyond, with growthreturning, but remaining at or below trend. In other words, realfactors will provide a strong disinflationary force for some timeto come.
World economy: output gap
%Source: IMF
Even if we disregard the output gap and its effects on inflationthere is other powerful evidence to suggest that a fragilerecovery will not lead to inflation.One of the most famous dictums of economics is that inflationis ultimately always a monetary phenomenon. Economictextbooks describe the process as starting with cash andreserves in the banking system (the “monetary base”). If thecentral bank increases the monetary base in a normallyfunctioning banking system, there will be a multiplier effect onloans. Banks lend out the excess cash they have, and in turnthese loans are spent and redeposited at banks. This in turncreates new bank lending power, new deposits and so on. Inthe US, for example, the money multiplier was around 9 up tothe beginning of last year. In other words, USD 1 of monetarybase supported around USD 9 in bank loans. This surge inloans in turn increases nominal purchasing power, and thiseventually results in a surge in prices. Today’s complex creditmarkets admittedly complicate the process, but this is the coreidea behind the famous dictum.
-6-4-20241980859095200051014
WorldAdvanced economiesEmerging economies
 
 13 May 2009 
SERDAR KUCUKAKIN +31 (0)20 629 5086 ECONOMICS DEPARTMENT
 
US: monetary base and money multiplier 
-2002040608010012000 01 02 03 04 05 06 07 08 09345678910
Monetary base (%yoy, lhs)M2 money (multliplier, rhs)
Source: Thomson Financial, calculations ABN AMRO Econ. Department.
So why don’t we believe this story? Firstly, in “normal” timesthis enormous increase in the size of central bank balancesheets would indeed lead to a huge jump in consumer purchasing power, with inflation as a result. However, there isnothing normal about today’s market: banks are not lendingand the surge in the monetary base is consequently piling up inexcess reserves. The above diagram shows that while themonetary base in the US has skyrocketed, the US moneymultiplier has collapsed.Secondly, historical evidence suggests that recoveries fromrecessions are “creditless”. If we zoom in on the US, we cansee that in the post-Second World War period (1951 - 2008)there was no correlation between bank lending to businessesand growth of GDP (0.22). In fact, the correlation between thetwo variables increases considerably if we lag credit growth bythree quarters (0.50).However correlation does not necessarily imply any causation.To overcome this shortcoming we have applied the Granger causality
1
test to see whether there is any causality betweenGDP and lending. This test suggests that a value of GDP in Tgives significant information about the value of lending in T+1.The outcome of these two econometric tools could at first sightbe counterintuitive because growth in credit could be expectedto lead to economic expansion. The reality would seem to bethat businesses only start borrowing when they see clear signsof recovery in the economy, or the flip side of the coin: banksonly become less cautious about lending when there are clear signs of recovery.Taking these observations as our starting point and also takinginto account that any recovery over the coming years, not onlyin the US but also in other major economies such as the euro
1
 
The Granger causality test is a technique for determining whether one timeseries is useful in forecasting another. A time series X is said to Granger-cause Y if it can be shown, usually through a series of F-tests on laggedvalues of X (and with lagged values of Y also known), that those X valuesprovide statistically significant information about future values of Y.
zone and Japan, will be fragile (partly because of thedisfunctioning of the credit market), there is little danger thatcredit growth will lead to a rise in inflation expectations.
Inflation expectations
How then can monetary policy today generate high inflationtomorrow? The answer lies on the first term of the Phillipscurve: inflation expectations. Inflation can increase simplybecause people expect inflation and so adjust their wages andprices accordingly to avoid being surprised by rising inflation.There are (theoretically) three relevant ways of loosening thegrip on inflation expectations in today’s economic environment.Firstly, as can be witnessed around the world, high levels of unemployment can prompt central banks to ease aggressively.However, systematic attempts to exploit the relationship behindthe inflation-output trade-off can backfire. A prolonged periodof easy money could result in businesses raising their inflationforecasts rather than hiring more people.The second risk of rising inflation expectations comes from theinteraction between the budget deficit and monetary policy.The US and other governments face major deficit and debtchallenges in the coming years. Normally an independentcentral bank would not be willing to monetize debt. In thecurrent economic setting, however, there is growing politicalpressure on central banks to offer a helping hand. In the US,Bernanke’s four-year term as Fed chairman ends in January2010, and a populist chairman might be tempted to reduce thereal value of debt by creating surprise inflation.
Government debt
% yoy
0510152025US Eurozone Japan UK
200820092010
Source: Thomson financial, forecasts ABN AMRO Economics Department.
Even without politicizing the central bank, debt dynamics couldforce the Fed’s hand, as central banks, preferring the lesser of two evils, may choose to monetize debt in order to avoid animplicit default. This risk naturally rises as the debt burdenbecomes higher. The huge increases in debt/GDP ratios over the next few years means this is a real concern, especially in ascenario of prolonged weak growth.
 
 13 May 2009 
SERDAR KUCUKAKIN +31 (0)20 629 5086 ECONOMICS DEPARTMENT
 
The final risk relates to the self-fulfilling nature of the need for astable store of value. Currencies are used as a store of valuein a low-inflation environment. However the risk of higher inflation may lead investors into other assets that hedgeinflation better. In other words, a prolonged period of ultra-easymonetary policy (= quantitative easing) can call into question acentral bank’s credibility and result in a move away from“nominal” assets, a dynamic that can itself fuel inflation.If we look at the three (theoretical) possibilities describedabove that could lead to rising inflation expectations, webelieve that the second and third could pose a threat further down the road. The rationale behind this thesis lies in theexpectation of a somewhat sluggish recovery of the economiccycle. Managing the exit strategy from quantitative easing (QE)and choosing the right exit tool and timing will be critical (theday after). We elaborate on this below.The first option – high and still rising unemployment levels thatcould tempt central banks to loosen more aggressively – haslittle relevance on a global scale because major central bankssuch as the Fed, the Bank of Japan and the Bank of Englandhave already slashed their policy rates close to zero and areapplying QE to battle the adverse effects of the credit crisis.Furthermore, although lagging somewhat behind, the ECB hasalso already lowered its policy rate by 325 basis points to1.00% since July 2008. Furthermore, ECB president Jean-Claude Trichet announced after the latest rate cut in May thatthe ECB would start 12-month refinancing operations. So far,the ECB’s refinancing operations have had a maximummaturity of six months. Trichet also announced that the ECBwould start building up a portfolio of covered bonds in order toimprove the functioning of this market.
 
Inflation
% yoy
-1012345600 01 02 03 04 05 06 07 08 09
USEurozoneUK
Source: Bloomberg
Market participants across the world have generally interpretedthese actions of the major central banks as being necessary. Inthe current setting, with a synchronized global downturn, thecentral banks are actually very keen to create some kind of inflation or expectation of inflation because battling deflation,once it gets anchored in people’s expectations, is more difficultthan battling inflation. Japan’s experience in the 1990s is thebiggest proof of this. Inflation rates across the globe havecome down significantly in recent months because of fallingconsumer demand and commodity prices.
US: inflation
% yoy
01234567880 84 88 92 96 00 04 08-202468101214
Expected inflation rate in 5 years (lhs)Actual inflation (rhs)
Source: Thomson Financial
Zooming in on the US, as shown in the above graph, we canindeed see that inflation expectations are currentlyconsiderably higher than actual inflation. However this doesnot mean that inflation expectations have recently risensignificantly. On the contrary, the current positive differencebetween expected inflation and actual inflation is attributablesolely to the fact that the latter has dropped sharply owing tofalling commodity prices and retreating demand. Inflationexpectations have actually been hovering between 3% and 4%since the beginning of the 1990s. In other words, the Fed hasbeen quite successful in anchoring inflation expectations for almost twenty years. This conclusion is very important becauseit shows that the American public has great trust in its centralbank and therefore, despite big swings in actual inflation, doesnot easily change its inflation expectations.
How to un-QE?
 While the markets have interpreted the current actions by thecentral banks as highly necessary in order to counter the verysharp economic downturn and the continuing disfunctioning of the financial system and although the current inflationexpectations seem well anchored, the public mood couldchange further down the road. At that juncture it will beessential for central banks to demonstrate their utmost skills toundo the current QE. In this respect the speed at which centralbanks can unwind their current positions is key tounderstanding the risks of inflation. We see three alternativeexit strategies:1.
Passive style
: A passive strategy in which central bankbalance sheets gradually shrink as short-term assetsmature and reserves are “returned”.
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