The link between Fed bond purchases and the subsequent growth of the money stock changed after 2008, because the Fed began to pay interest on excess reserves. The interest rate on these totally safe and liquid deposits induced the banks to maintain excess reserves at the Fed instead of lending and creating deposits to absorb the increased reserves, as they would have done before 2008.
As a result, the volume of excess reserves held at the Fed increased dramatically from less than US$2 billion in 2008 to US$1.8 trillion now. However, the new Fed policy of paying interest on excess reserves meant that this increased availability of excess reserves did not lead after 2008 to much faster deposit growth and a much larger stock of money.
The size of the broad money stock (known as M2) grew at an average rate of just 6.2 percent a year from the end of 2008 to the end of last year. While nominal GDP generally rises over long periods of time at the same rate as the money stock, with interest rates very low and declining, households and institutions were willing to hold more money relative to total nominal GDP after 2008. So, while M2 grew by more than 6 percent, nominal GDP grew by just 3.5 percent and the GDP price index rose by only 1.7 percent.
So it is not surprising that inflation has remained so moderate — indeed, lower than in any decade since the end of World War II. It is also not surprising that quantitative easing has done so little to increase nominal spending and real economic activity.
The absence of significant inflation in the past few years does not mean that it will not rise in the future. When businesses and households eventually increase their demand for loans, commercial banks that have adequate capital can meet that demand with new lending without running into the limits that might otherwise result from inadequate reserves.
The resulting growth of spending by businesses and households might be welcome at first, but it could soon become a source of unwanted inflation.
The Fed could, in principle, limit inflationary lending by raising the interest rate on excess reserves or by using open-market operations to increase the short-term federal funds interest rate. Yet the Fed may hesitate to act, or may do so with insufficient force, owing to its dual mandate to focus on employment as well as price stability.
That outcome is more likely if high rates of long-term unemployment and underemployment persist even as the inflation rate rises. That is why investors are right to worry that inflation could return, even if the Fed’s massive bond purchases in recent years have not brought it about.
Martin Feldstein is a professor of economics at Harvard University and president emeritus of the National Bureau of Economic Research. He chaired former US president Ronald Reagan’s Council of Economic Advisers from 1982 to 1984.
Copyright: Project Syndicate