The Federal Reserve has headed off a deflationary depression for the U.S. economy. It did so by printing money and pumping it into the banks and the credit markets. Now, signs of an impending upturn in the economy are increasing and even economists Nouriel Roubini and Paul Krugman have said that the recession is likely to end this year.
However, the vigorous creation of money has aroused fears among many that inflation will arise,quickly get out of control and, possibly, turn into hyperinflation.
Analysis of the money supply data shows that such fears are premature. The record-breaking expansion of bank reserves (about 900%) simply has not leaked out in a meaningful way into M2, which is the broad money supply used by businesses and consumers.
This measure of money, M2, has increased by 9% in the past year, but the rate of increase is decelerating: 6% (annual rate) since the end of last year and only 4% over the last three months. This is way lower than in the early 1980s, when all measures of money were growing at more than 10% and their rates of growth were accelerating.
Then, double digit money growth led to double-digit inflation. It is possible that the fear-mongers of inflation will be right in the long run, but it is way, way too early to jump to that conclusion at this point.
Critics of the Fed believe that as the economy recovers, the Fed will be afraid of angering the administration and the public by raising interest rates too soon, which could torpedo the upturn (the Fed made that error in 1937 and turned a recovery into Chapter 2 of the Depression). They claim that keeping rates low for too long will allow inflation to gain traction. They overlook the fact that Bernanke can first head off inflation by undoing quantitative easing (sell into the market those securities that had been purchased with the newly printed money, and then retire the moneys received for those securities).
This can be done quietly, without generating criticism, since no interest rates need be increased. Rates will remain stable as private capital from a growing economy replaces that of the Fed. The Fed’s next step will then be to raise rates, but they are at such a low level now (0 - 0.25 %) that it is hard to see how raising the Fed Funds rate sharply to 1% or even 2% can be feared as providing much of a brake on a growing economy.
Once the economy gets rolling, it will likely gain momentum for three reasons:
- There is much unused capacity and production can be increased quickly and easily.
- Inventories are very low and have been dropping for months. Production will have to increase just to match the present low level of sales in many industries. As sales increase, production will have to increase even more to bring inventories to a higher level.
- Employers who have cut employment to the bone will have to hire early in the business cycle to meet demand for their products and services.
As the economic recovery takes hold, the Fed will sop up much of the newly printed money, then gradually raise interest rates. Those concerned that inflation will get out of hand would do well to monitor the M2 money supply as a necessary precursor of inflation.