Inflation and the Fed

During the current economic crisis, the Federal Reserve has increased its balance sheet significantly in order to increase the monetary liquidity in the economy. Many people assume they have done this by “printing money” which in theory increases the money supply held by the public and over the long term is inflationary. However, because the Fed did not want to increase the actual money supply held by the public, they went about increasing the liquidity of the system in a different manner, one that they are convinced will allow them to avoid unsustainable inflation in the future. Theoretically, this is true. However, in reality, it’s likely to be false for a reason I’ll get to in a minute.

First, we need to understand exactly how the Fed increased economic liquidity without increasing the money supply in public hands. James Hamilton gives us a very thorough explanation. I highly suggest you read the whole thing which is liable to lead you down a very deep rabbit hole but I’ll try to summarise to the best of my abilities. Normally, if the Fed wanted to increase liquidity, it doesn’t physically print money and start handing it out to the people on the front steps. Most large banks have an account with the Fed. To get money into the system, the Fed normally just adds an entry in one of these accounts as a sort of deposit. The bank now has more money than it did before. It can then use that money to pay off debt, to loan out to other banks or customers or ask for actual money. Typically they do the one of the first two and not the other. This may go on for several steps but eventually, someone wants the actual money and the original entry gets converted to cold hard cash.

That of course would increase the money supply held by the public. The Fed did two different things to increase the liquidity without increasing the money supply. First, it asked the Treasury to borrow a bunch of money by selling T-Bills to banks. Those banks paid for the T-Bills by asking the Fed to transfer money from the accounts at the Fed to accounts at the Treasury. The Treasury then just sits on the money and you have no increase in money supply held by the public.

The second way the Fed increased liquidity was by changing the terms of the accounts they held with the banks. In the past, if the Fed added an entry to a bank’s account, the bank would put that money to use, typically by lending it out overnight. They did this because the Fed did not pay interest on any money that sat in the account overnight and the bank could get interest in the overnight lending trade. However, during this crisis, the overnight lending trade came to be viewed as suspect by most banks because they didn’t know what banks were solvent and what banks weren’t. So they weren’t inclined to lend that money out and the Fed helped them out by starting to pay interest on accounts. Now, the banks could just leave the money sitting there and still make money. This situation allowed the Fed to essentially borrow directly from the public because they can increase account balances without having to worry about money getting into the system.

Of course, all of this is still inflationary because money is essentially being created out of thin air. Plenty of people worry about this and Ben Bernake wants people to know that they have a plan for getting out of the situation once the economy turns around which he detailed in the Wall Street Journal Op-Ed linked above. He argues that the Fed can just increase the interest rates it pays on the accounts banks hold with it once the economy turns around. By increasing the interest rates, it can ensure that banks will continue holding money with the Fed instead of loaning it out to the public.

This is where theory is going to meet reality in what is liable to be a very ugly street fight. Increasing interest rates sounds real easy but in fact, is a highly political process, one that Alan Greenspan failed at spectacularly in 2002-2003 when the economy was coming out of recession. Increasing interest rates naturally inhibits growth because it is more expensive to borrow money to fund expansion. Imagine a scenario where we start to come out of the worst recession we’ve seen since WWII. Unemployment is starting to level out, probably around 11% or so. Spending is starting to increase somewhat. If suddenly growth starts to shoot up a little, banks will be inclined to lend that money that the Fed gave them out. If at this point, the Fed raises interest rates, it takes a huge political risk in that it may nip the growth in the bud and return us to a recession. Can you imagine the political fallout from a move like that? The electorate would scream bloody murder and whoever was in charge at the Fed would be the scapegoat. In reality, the interest rates probably wouldn’t get raised at all and once the banks started lending that money out, we’d see a highly inflationary environment.

Because the plan the Fed has is in effect a political plan and not a monetary plan, it is likely to be a broken plan from the outset. The US economy is headed towards a precipice with a tiny tightrope to the other side, on one side of the rope is long term stagnation and on the other a hyper-inflationary scenario that turns us into Argentina or worse, Zimbabwe. I highly doubt that we will have the ability to walk the tightrope between the two and will likely end up in the second situation because it will be an easier political decision to make. This is the problem that comes up when you have highly technical people in control of what is essentially a political problem. In theory, their reasoning goes, we can fix this, no problem. In reality, it’s never that easy.