20 Dec 2008

Why Aren’t the Fed Injections Leading to Massive Price Inflation?

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As longtime Free Advice readers know, my favorite graph lately has been of the monetary base, which consists of currency plus bank reserves on deposit with the Fed. (Note that a broader definition of money, M1, includes total demand deposits, i.e. checking accounts, whereas the monetary base doesn’t.) In contrast to the broader measures of money, the Fed can directly control the monetary base through open market operations (and other ways if need be), and that’s why most economists look at the behavior of the monetary base to see whether the Fed is tightening or loosening.

Anyway, the graph below illustrates the old “pushing on a string” notion of impotent money-pumping. In the past year the Fed has pumped in a ridiculous amount of bank reserves–meaning that the Fed goes out into the market and buys assets such as government debt or even mortgages from institutions, and then out of thin air increases the electronic entries for their deposit balances with the Fed itself. But as you can see, the increase in reserves is basically just sitting in the (electronic) vaults on the Fed’s ledger. Even though banks have the legal ability to make new loans to customers (which would increase M1, M2, MZM, etc. by more than the base itself increased), they aren’t doing so. In other words, the total amount of checkbook balances (as well as other very liquid forms of money included in the definition of M1) has gone up sharply, but not nearly as much as the base has increased (an increase itself driven by the spike in one of its constituents, reserves).

Here’s another way to view it. “Excess reserves” means those reserves that banks hold on deposit with the Fed, that they don’t need to back up their outstanding demand deposits. So when excess reserves rise, that means banks have the legal ability to make more loans but are choosing not to. Now I’m just eyeballing it here, but if you look closely you can see an uptick in recent months…

But back to the serious issue at hand: What happens when the panic in the financial sector subsides, and banks feel comfortable lending again? Well, loosely speaking, it means that the amount of money in the hands of the public (as opposed to reserves that commercial banks have on deposit with the Fed) can increase the same percentage as reserves have increased. So even if Bernanke cut the spigot off Monday, and didn’t let reserves increase any more, that would still mean there was enough slack in the system for demand deposits to increase some 1,400%. (Reserves have gone up yr/yr a bit more than that, while demand deposit year/year growth has been around 38% or so.)

Now obviously Bernanke is not going to sit back and let prices go up by a factor of 14. But how does he suck reserves out of the system? Why, he has to sell off the trillions in new assets that the Fed has recently acquired. And of course, this is precisely all of the “troubled” assets that nobody wanted to hold in the first place, and that had caused the major players to seize up.

And even if Bernanke decides to hang on to all of the mortgage derivatives–you know, the ones that are going to make us taxpayers so much profit in the coming years–and he just dumps U.S. Treasurys, guess what that does? It lowers the price of Treasury debt, meaning interest rates rise. Fortunately, the incoming Obama Administration has plans to sharply pay down the federal debt, so at least skyrocketing interest rates won’t be so painful. Oh wait.

I hope my advice to acquire physical gold and silver makes more sense now. And I hope you also see why I find all this talk about the market forecasting 30-year average inflation rates of 2 percent (or whatever) to be absurd.

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