Money: ‘Printing money’ – it will be inflationary, won’t it?
22 May 2020
Yes, we hope so. That is the point of it. Without it we would get deflation, which is worse.
The Reserve Bank of New Zealand is doing what all central banks around the world are doing in this Covid-19 world, printing money. Around $1,300,000,000 a week in New Zealand in recent times.
Some concerned clients have been asking me whether printing this amount of money is inflationary and it is. But that is the point. We need some inflation in the next wee while to counteract the loss of jobs, loss of income and the increase in fear.
Deflation we want to avoid. It can become a dreadful spiral downwards. The Great Depression of 1929 to 1933 was a time when deflation was allowed to develop. We must dodge deflation if we can.
The response by governments around the world to the Covid-19 health crisis was to turn off a large amount of commerce. When businesses shut up for two months there was a lot of money that no longer circulated around the economy and printing money is one way to fill the gap.
A good analogy involves dirt. We woke up one day in late March 2020 to find that we had a big hole develop in our economic world. It is the Reserve Bank’s job to fill up that hole with new dirt. If they shovel in too much dirt we will end up with a mountain and get too much inflation down the track. If they do not shovel in enough dirt, we will still have a hole and end up with more people unemployed than necessary, a depression.
We do not want too much dirt. We do not want too little. We want ‘just right’. The Goldilocks solution.
Eventually, some of this extra money will have to be carefully withdrawn from the economy. The right time to do that is when the economy heats up again and by taking some money out of the economy the Reserve Bank will be trying to stop inflation getting away from us. That is not a problem today. A slowing economy is the problem.
How does it work?
The Reserve Bank is the originator of all New Zealand money and it can increase or decrease it at any time. It operates under a binding agreement with the government to keep inflation within the bounds of 1% to 3% per annum and to consider the level of employment as well.
To ‘print money’ the Reserve Bank goes into the bond market and buys up bonds from investors, like your Kiwisaver fund, who might want to sell them. Cash changes hands moving from the Reserve Bank to the person who previously owned the bond. If no one wants to sell their bonds the Reserve Bank can raise the price they are willing to pay until an investor thinks it is too good a deal, and snaps it up.
Then the investor who has just sold a bond to the Reserve Bank has to do something with their cash. They can spend it, save it in the bank, buy shares with it, pay off debt, buy a business. The net result is that there is now more money in circulation which is highly likely to stimulate some economic activity in our economy.
The other result of the Reserve Bank buying bonds at inflated prices is that it forces interest rates down. If the Reserve Bank is willing to pay $110 for a bond that was selling at $100 the day before, the effective return (yield or interest rate) that the bank is receiving for the bond that they now own is lower. The interest payments from the bond stay the same while the capital cost of the bond has gone up. The numerator stays the same while the denominator has increased. Convert this to a percentage and the result must be a lower effective interest rate. (Ignore this explanation if your fractions are a bit rusty.)
The interesting thing here is that no money is actually printed by the Reserve Bank. It is just a metaphor. Rather, money is created as a number on the Reserve Bank’s balance sheet and then transferred to a trading bank’s balance sheet belonging to one of its customers.
Quite a tricky system. To get your head around it one needs to understand how bonds work. Se article on bonds here.
When the government decides to do its bit to stimulate the economy, independent of the Reserve Bank, it increases government spending, increases payments to beneficiaries or decreases taxes. It funds this by borrowing from the bond market, just like any business. It issues new bonds called government stock. When investors (including the Reserve Bank now) buy these bonds they are holding a contract (a bond) to receive a stream of interest payments and the capital back from the government at maturity. The government gets cash in return to pay for its activities.
The government is not therefore responsible for creating money. They just borrow from the bond market like everyone else.
What is inflation?
Inflation is the price of goods and services going up.
A little bit of inflation is considered good as it indicates economic activity is increasing. It encourages spending and helps stimulate economic growth. It encourages borrowing and lending and helps borrowers to pay back their loans with money that is less valuable than the money they originally borrowed.
Too much inflation and it starts to influence spending behaviour with people buying before the price goes up. Also, inefficient businesses can hide behind price increases and not be found out. People on fixed incomes are worse off. Not good. Been there, done that.
The annual inflation rate at the end of 1918 in New Zealand was 44%. Reverting to my lifetime, inflation was nearly 18% for the year to the end of March in 1976. It was economic chaos.
Inflation of 3% per annum is considered a safe top level. 1% per annum, a safe bottom level. 2% per annum, just right.
Let us try and stick to that. It serves savers and borrowers reasonably well and helps grow the economy as our population grows.
In the meantime, print money, borrow and spend. It is your patriotic duty. Get our economy going. Then, once the money is churning around again and the good times have returned, pull back a little. Re-charge your emergency funds, pay off some debt. Delay some non-essential spending.
In other words, do the opposite of what you might feel like doing. Think it through. Use your head, not your heart. Don’t let fear get a hold of you at this time.
“Be greedy when others are fearful; be fearful when others are greedy.” Guess who said that?
Keep asking great questions …
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