Fed's Expansion of Balance Sheet No Cause for Inflation Worries

I have heard the common argument over and over with regards to the Fed expanding their balance sheet. The argumnent goes something like this "The Fed is just printing money and Inflation is comming, better run to gold to protect us from this tsunami of inflation. That argument is just outright flawed.

The Federal Reserve is doing the right thing by expanding their balance sheet for numerous reasons, one of importance is to reduce mortgage rates. However I can go on about why they need to expand, but everyone I talk to keeps bringing up the argument of inflation. They say there are going to be too many dollars chasing too few goods. Well my friends, the global economy is at the lowest point of utilization of capacity in over seven decades. As the economy swings back, capacity will have to be worked off before inflation can take hold (just as the housing inventory must be worked off before prices can rise again). Which is a main reason we will see low investment spending by companies in the comming years.

Secondly, and most importantly we need to think about how those fresh dollars are being put to use in the market. Those dollars are hanging on bank balance sheets as capital reserves in exchange for assets held by the Fed. When it comes time for the Fed to unwind their balance sheet, those dollars will be in effect "unprinted" and taken back out of the money supply. This process can happen very quickly, unlike Fiscal policy. And wa-lah the money supply is back to normal and the Fed balance sheet is also back to normal.

Goldman Sachs doesn't see inflation picking up until the second half of next DECADE! Well, I have other things to worry about in the meantime. One is deflation. I am more concerned about deflation then possible inflation. A Goldman Sachs economist also noted every $1Trillion of Fed expansion is equivalent to approx 100bp of monetary easing. GS predictions put the theoretical Fed funds rate at -8% by the end of 2010. This is of corse impossible, and since we are already at zero, the Fed has started to participate in various programs such as TALF, buying Treasuries, etc. to artificially lower the Fed Funds rate. Using the Goldman Sachs estimate of $1T for 100bp, we are currently at -2%, which is about where we should be looking at Goldman's chart. This indicates we're on track for another $4-6T of balance sheet expansion going into 2010.

Disclosure: No positions

Comments

[User 143167:]

It is either depression or stagflation. Currently, it is still a depression, so the FED has to create more money, then we will hit stagflation once the demand begins to recover and money flows again.

But you are totally wrong about the relationship between capacity usage and inflation. Check out those numbers in 1970s. Capacity usage was as low as today while inflation was high.

Apr 08 06:15 AM

[Carlos Lam:]

Mr. Pease, you write that "When it comes time for the Fed to unwind their balance sheet, those dollars will be in effect 'unprinted' and taken back out of the money supply." Your view is either incredibly naive or tenaciously optimistic. First, if and when the economy gets moving again, the Fed is going to come under extreme political pressure from Congress and the Executive Branch to not move too quickly lest economic improvement cease and imperil their re-election efforts. While the Fed is supposed to be independent, the close coordination between the Fed and Treasury has been on display since the beginning of this morass. Finally, Chmn. Ben Bernanke's term expires in 2010; if he wants to be re-appointed, then he has an incentive to listen to the politicians' pleas.

Second, the same Fed with which you clothe such acumen is the same body that has behaved so ineptly during this entire episode. On Oct. 7, 2008, Fed Chmn. Bernanke told an NABE audience that the $700 billion TARP was "an authorization to purchase financial assets" even though the TARP was then used to re-capitalize banks. Chmn. Bernanke eschewed transparency (in a republican form of government, no less!) by stonewalling Bloomberg's FOIA request. He is a man who claims to be a student of the Great Depression and Japan's Lost Decade yet is repeating the same mistakes made during those eras without cogently explaining WHY this time the results will be different. This Fed Chairman has been monumentally inept at every turn. His prior ineptitude should lead us to question his ability to make the correct decisions at this time.

Apr 08 06:18 AM

[Canadian Guy:]

"Well my friends, the global economy is at the lowest point of utilization of capacity in over seven decades."

You also seem to be basing this on the assumption that all of the capacity that existed at the start of this recession/depression will still be in existance when we finally start recovering.

Up here in Canada that simply won't be so. Factories (capacity) close by the dozens EVERY DAY in Ontario and Quebec. The equipment is sold off, but most likely scrapped for a pittance of its former value. These jobs and this capacity will not return when demand does.

Isn't the lack of supply and increasing demand the classic recipe for inflation? The demand will eventually be there too since the North American savings rate is currently hitting levels that it has not been at for decades. That money has to go somewhere.

And in case you haven't been paying attention around the globe in places like China, Japan, Vietnam, South Korea, Indonesia and Mexico, factories are permanently closing and companies going bust there at record numbers too. The loss of capacity will be a world wide phenomenon as will the ensuing inflation.

Apr 08 08:57 AM

[ECONOMICS 101:]

Any way you look at it it = 'INFLATION"

Apr 08 09:36 AM

[dybydx:]

Its true that most of the balance sheet expansion remain "unprinted"... for now. However, this assumes those banks and the rest of the econ will get their act together and start pumping out some real GDP growth. If that growth is below expectation, the fed will be forced to either print rest of its balance sheet or have the US gov issue more debt to keep bailing out firms. The US gov is already stretching their limit of debt issuance as fewer and fewer buyers are willing to buy. So at some point the balance sheet will get printed on greenbacks.

Apr 08 09:43 AM

[Tony Daltorio:]

You are missing two points. First, productive capacity and employment are being slashed perhaps quicker than it ever has before. This will lead to capacity constraints and inflation as soon as the economy has even a sniff of a turnaround.

Second,you are missing the point all the deflationists miss. Is it a law written on some stone tablet that the Fed has to use the failed banking system to get money out into the economy? They are already bypassing the banks in many instances. Have you ever thought that if things get bad enough maybe the Fed will just distribute money directly to the populace?

Apr 08 10:00 AM

[Dave Wrixon:]

The only thing that is going to get deflated is the exchange rate of the dollar!

Apr 08 02:10 PM

[CJ-49:]

Agree with Ceti, nicely put. But your audience is mostly brain dead.

Apr 12 07:18 AM

[Rohan C. Pease:]

"According to an internal analysis prepared for the Federal Reserve's last policy meeting, the ideal interest for the U.S. economy right now would be -5.0%. The analysis is based on the Taylor-rule approach, which estimates appropriate interest rates based on unemployment and inflation. Though a central bank cannot cut interest rates below zero, the research suggests the Fed should use unconventional policies to create the equivalent of a minus 5 percent interest rate."

Apr 27 11:39 AM