Inflation is now low in every industrial country, and the combination of high unemployment and slow GDP growth removes the usual sources of upward pressure on prices. Nevertheless, financial investors are increasingly worried that inflation will eventually begin to rise, owing to the large expansion of commercial bank reserves engineered by the US Federal Reserve and the European Central Bank (ECB). Some investors, at least, remember that rising inflation typically follows monetary expansion, and they fear that this time will be no different.
Investors have responded to these fears by buying gold, agricultural land and other traditional inflation hedges. The price of gold recently reached a four-month high and is approaching US$1,700 an ounce. Prices per acre of farmland in Iowa and Illinois rose more than 10 percent over the past year. And the recent release of the US Federal Reserve Board’s minutes, which indicate support for another round of quantitative easing, caused sharp jumps in the prices of gold, silver, platinum and other metals.
However, unlike private investors, Fed officials insist that this time really will be different. They note that the enormous expansion of commercial banks’ reserves has not led to a comparable increase in the supply of money and credit. While reserves increased at an annual rate of 22 percent over the past three years, the broad monetary aggregate (M2) that most closely tracks nominal GDP and inflation over long periods of time increased at less than 6 percent over the same three years.
In past decades, large expansions of bank reserves caused lending surges that increased the money supply and fueled inflationary spending growth. However, now commercial banks are willing to hold their excess reserves at the Fed, because the Fed now pays interest on those deposits.
The ECB also pays interest on deposits, so it, too, can in principle prevent higher reserves from leading to an unwanted lending explosion.
The Fed’s ability to pay interest is the key to what it calls its “exit strategy” from previous quantitative easing. When the economic recovery begins to accelerate, commercial banks will want to use the large volume of reserves that the Fed has created to make loans to businesses and consumers. If credit expands too rapidly, the Fed can raise the interest rate that it pays on deposits.
Sufficiently high rates will induce commercial banks to prefer the Fed’s combination of liquidity, safety and yield to expanding the quantity of private lending.
That, at any rate, is the theory; no one knows how it would work in practice. How high would the Fed — or the ECB, for that matter — have to raise the interest rate on deposits to prevent excessive growth in bank lending? What if that interest rate had to be 4 percent or 6 percent or even 8 percent? Would the Fed or the ECB push its deposit rate that high, or would it allow a rapid, potentially inflationary lending growth?
The unusual nature of current unemployment increases the risk of future inflation still further. Nearly half of the unemployed in the US, for example, have now been out of work for six months or longer, up from the traditional median unemployment duration of just 10 weeks. The long-term unemployed will be much slower to be hired as the economy recovers than those who have been out of work for a much shorter period of time.