The Fed’s Balance Sheet and Inflation

I sat in on a presentation this week where a picture of the Fed's balance sheet growth was shown as prima facie evidence that inflation looms down the road. The presenter wasn't sure when inflation would arrive, but it would arrive and be caused by the balance sheet expansion. No chain of causality was laid out. Just balance sheet expansion then, later, inflation.

He may be right, but I don't think so. It may happen, but it isn't an inevitable result of the balance sheet growth. Here is my reasoning:

1. The first point I would make is that all the balance sheet expansion took place last fall. There has been no further expansion since December-7 months ago.

2. The composition of the balance sheet was not mentioned; so, the impression was left that the total expansion of assets was relevant; not just the part that expands bank reserves and cash in circulation-the monetary items on the liabilities side of the Fed's balance sheet. Assets that support such other liabilities, such as debt to foreign central banks under swap arrangements probably shouldn't be counted.

3. The monetary base did rise sharply in the fall, as is shown dramatically by graphs that have their horizontal axis squeezed up to collapse time. But that growth, also, is pretty much behind us and over with.

4. More importantly, regarding the monetary base, much of the dramatic rise may be attributed to banks voluntary holding excess reserves at the Fed, perhaps in part because the Fed is now allowed to pay a nominal interest rate on them, but, more importantly, because given the stress and uncertainty facing the banks, banks don't necessarily regard them as excess. They probably regard them as necessary precautionary balances, as they did in the mid-1930s.

5. The Fed made a huge mistake in the mid-1930s by thinking of those reserves as "excess" and deciding to "mop them up" by increasing reserve requirements to give it closer control over reserves in conducting monetary policy. As a student of the Great Depression, Chairman Bernanke knows that history very well and is unlikely to repeat the Fed's mistake. Apparently, however, most of the talking heads on financial TV are not familiar with it and, therefore, they say strange and dangerous things about the presence of today's excess reserves.

6. The monetary base is not money to be spent for goods and services. The monetary base is not money. Rather, it's the raw material from which money is created. M1 and M2 and other measures of money also slowed down dramatically after their initial spurts last fall and are growing much more modestly today-not at a pace we usually regard as inflationary.

7. Chairman Bernanke has said several times publicly that he didn't anticipate problems letting his balance sheet shrink when conditions return closer to normal and less money is needed. Surly he can get the timing approximately right. The recent changes in the composition of the balance sheet augur well.

8. Meanwhile, the time to shrink is not close. The velocity of money obviously declined dramatically as money growth accelerated months ago. Under those conditions, rapid money growth is needed to prevent deflation. Anticipating velocity changes may be hard, but seeing them after the fact is rather easy. Just divide GDP (P x Q in the equation of exchange) by M (whichever definition of money you fancy) and you get the income velocity of that measure of money. Having GDP growing slower (negative lately) than M is growing tells you that V is declining.

Put another way: Money doesn't cause inflation; spending money may cause inflation. Money is not being spent at a sufficient rate lately to cause inflation.

9. Switching from money to credit, in this financial crisis, various forms of credit have dried up. Bank credit is just one component of total credit. The decline of nonbank credit leaves a large hole to be filled by bank credit until things return to normal. That's what Chairman Bernanke is doing as he purchases debt (assets) other than treasury debt-commercial paper, mortgage-backed securities, packaged student loans, auto credit, etc. Focusing on these purchases and not realizing the hole he is trying to fill would lead you to believe, falsely in my opinion, that seeds of future inflation are being sowed.

10. Some arguments for the inevitability of a sharp acceleration in inflation rather carelessly lump together with the Fed's balance sheet the Treasury debt created to finance the stimulus package, Tarp, and the large budget deficits that we are experiencing. Doing that leads to very large numbers, so isn't inflation inevitable?

The economic theory that I remember says that the inflationary impact of fiscal deficits depend almost entirely on how they are financed, i.e., whether new money is created in the process. Growing deficits without comparable monetary expansion will push interest rates up sufficiently to get the debt purchased. Higher interest rates are likely to crowd out private investment as the government commands more and more of the financial resources. This is not a good outcome, but it's not inflation.

11. Bottom line: I don't think a sharp increase in inflation is in the cards. However, it seems that just about everyone else does. Given the shrinkage in my own modest portfolio in late 2008 and early 2009, I view my own expectations with a greater degree of modesty than before. As Dennis Miller says: I may be wrong!

12. Therefore, I'm not arguing that inflation hedges shouldn't be a part of a diversified portfolio. They are good for peace of mind, especially if your fear of inflation is greater than mine. Given our recent experience, we should all follow the familiar adage to some degree: expect the best, but prepare for the worst.

Comments (4)

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  1. My concern isn’t the Fed’s ability to make the shift from looser monetary policy to tighter policy. My fear is that political pressure could have an impact on the Fed’s decision making process. Perhaps, the FOMC won’t be able to tighten as quickly as needed.

    I realize that, in theory, the Fed should be immune from the bulk of political pressure. However, government intervention seems to be the all the rage. I’m most afraid that the president will try to replace Bernanke. I’m inclined to believe that Bernanke knows how to navigate the hurdles ahead. My hope is that he and the Fed aren’t swept up in the collateral damage of government activism gone wrong.

  2. Dean Packard says:

    Very insightful. I find it extremely interesting to watch and observe the entire impending inflation clock tick down.

    It strikes me as odd that so many people have become such expert economists at precisely the same time as so many people have overseen the erosion of the value of their personal nest egg. Rarely are the masses correct.

    Don’t the labor market and globalization also portend favorably for downward pressure on inflationary tendencies? In 1974 I believe I recently read, there were something like 400 labor actions (aka strikes). Virtually all were about cola demands. In other words folks were willing to go without for a period of time just to defend their right to break even purchasing power wise. The result was a nasty bought of wage push inflation if memory serves me correctly.

    Contrast that to 2008. I think the same source (I believe it was the chief strategist at JP Morgan) referenced that there were only 4 labor actions last year. All 4 were about shipping jobs overseas. In other words, holding out to try and force their employer to overpay them for the same work that could be purchased elsewhere.

    Labor is a very large part of the cost of goods sold. so it seems to me to reason that a strong technology and innovation led productivity surge combined with a relatively weak labor movement and global trade still much more open than in any time in history all add up to the fact that making a price increase stick will be a very challenging proposition.

    I am not saying it cant happen, of course. I just am inclined to agree with you that it is not a foregone conclusion that 70s style inflation awaits us in the near future.

    I see it as flawed investment policy to hold everything in .18% treasuries while you wait for 18% treasuries to come back.

    I worry more about the dollar, aging boomers, and the economic impact of any setbacks in the global war on terror — but those are concerns for a different response.

  3. a says:

    yeah, sure. as soon as they see a recovery the fed will kill it by shrinking the money supply and raising rates. whatever.

  4. anon says:

    Sorry, there is no such Fed balance sheet category as:

    “other liabilities, such as debt to foreign central banks under swap arrangements”

    Foreign currency liquidity swaps create additional bank reserves, other things equal.