Several weeks ago I reiterated a concern of mine that eventually this financial crisis, along with the massive stimulus package in the US, will lead to much higher rates of inflation than many people are expecting in two, three or four years down the road. Link here. My general concern was that the reserves of rhe US banking system have sky-rocketed (see graph in the original piece) and that eventually these higher reserves will lead to a large rate of growth in the money supply and in aggregate demand.
After I wrote that piece, colleague David Laidler wrote to me,
I think you'll find that the US monetary base grew steadily from 1929-33. What matters on this front is the growth of money relative to the demand for it, and base growth has never been the principle driver of money growth at business cycle frequencies. Prices have been falling since late summer, and as the real economy continues to fold, chances are that will continue. So I'll start worrying about inflation in around 2011 - that is if the currently in place measures do manage to stop the US contraction by the end of this year, which I doubt.
I generally am happy to defer to David on monetary issues. Further, if we put his caution together with the persistent argument by Scott Sumner (and which I also raised last December) that paying interest on reserves is counter productive to increasing banks' reserves to try to stimulate the economy, then we have a short-term problem that is quite different from the problem that concerned me in that posting.
It looks as if that good old money multiplier that we teach our intro economics students has a LOT of slippage in it. Bank reserves and high-powered money do not automatically lead to a definite, easily calculated quantity of money in the economy, especially not in the short-term.
So here is the way I see what has happened and what will happen.
- Credit crunch caused by a bunch of bad loans and bad financial insurance (and whatever caused those things to occur)
- Fed tries to pump up aggregate demand, get credit flowing again, by boosting banks' reserves.
- But the banks are scared and would prefer sitting on the reserves rather than using those reserves as a basis for new loans.
- Fed offers to pay interest on reserves, exacerbating previous point. Banks say "Why make risky loans when we can now earn interest on our reserves (deposits at the Fed)?"
- So as reserves increase, the actual money supply continues to decrease, raising continuing fears of deflation.
- But all those reserves still exist, and the Fed will not find it easy to reduce them as necessary in a quick and timely fashion in the future.
- So as the US comes out of the recession/depression, there will be a tonne of cash available to fuel inflation.
- AND, how on earth is the US gubmnt going to finance its huge and growing debt? Tax the rich, but that can't do the whole job. It will have to monetize much more of the debt.
Despite the recession the US is in now, and despite the deflationary pressures they are experiencing now, I still don't see how all these reserves and the skyrocketing debt cannot eventually lead to rapid price inflation in the future.
Note: I think paying interest on bank deposits with the central bank is probably a good idea. My concern stated above is that they chose just about the worst time in the past 25 years to implement the policy.