Thu, Apr 05, 2012 - Page 9 News List

The US Federal Reserve’s policy holds an inflationary risk

The US’ large volume of reserves, together with enormous liquidity created by the Fed’s quantitative easing, are ideal breeding grounds for inflationary pressures

By Martin Feldstein

During the past four years, the US Federal Reserve has added enormous liquidity to the US commercial banking system and therefore to the US economy. Many observers worry that this liquidity will lead in the future to a rapid increase in the volume of bank credit, causing a brisk rise in money supply — and the subsequent rate of inflation.

That risk is real, but it is not inevitable, because the relationship between the reserves held at the Fed and the subsequent stock of money and credit is no longer what it used to be. The explosion of reserves has not fueled inflation yet and the large volume of reserves could in principle be reversed later. However, reversing that liquidity may be politically difficult, as well as technically challenging.

Anyone concerned about inflation has to focus on the volume of reserves being created by the Fed.

Traditionally, the volume of bank deposits that constitute broad money supply has increased in proportion to the amount of reserves that the commercial banks had available. Increases in the stock of money have generally led, over long periods, to increases in the price level. Therefore, faster growth of reserves led to faster growth of money supply — and on to a higher rate of inflation. The Fed in effect controlled — or sometimes failed to control — inflation by limiting the rate of growth of reserves.

The Fed began an aggressive policy of quantitative easing in the summer of 2008 at the height of the economic and financial crisis. The total volume of reserves had remained virtually unchanged during the previous decade, varying between US$40 billion and US$50 billion. It then doubled between August and September of 2008, and exploded to more than US$800 billion a year later. By June last year, the volume of reserves stood at US$1.6 trillion and it has since remained at that level.

However, this rise in reserves did not translate into rapid growth of deposits at commercial banks, because the Fed began in October 2008 to pay interest on those reserves. Commercial banks could place their excess funds in riskless deposits at the Fed, rather than lending them to private borrowers. As a result, money supply has grown by only 25 percent since 2008, despite the 40-fold increase in reserves since that time.

During the past year, the Fed has further increased the liquidity of the banking system — and of the US economy — by a strategy called Operation Twist, buying US$400 billion of long-term securities in exchange for short-term US Treasury bills. The banks that hold these Treasury bills can sell them at any time, using the proceeds to fund commercial lending.

The massive substitution of reserves for longer-term securities during the period of “quantitative easing,” and of Treasury bills for long-term securities in Operation Twist has succeeded in reducing long-term interest rates. The combination of low interest rates at every maturity and the substitution of short-term securities for longer-term assets has also succeeded in raising share prices.

However, it is not clear that the lower interest rates and higher share prices have had any significant effect on real economic activity. Corporations have a great deal of liquidity, and they do not depend on borrowing to invest more in plants and equipment. Housing construction has not revived, because house prices are falling. Consumers temporarily increased their spending in response to the increase in the stock market at the end of 2010, but that spending has recently been much more sluggish.

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