Where's The Inflation?

by: Bob McTeer

Going through some newspaper clippings the other day, I ran across an opinion piece in the Wall Street Journal titled, "Get Ready for Inflation and Higher Interest Rates." The fourth paragraph is quoted below:

But as bad as the fiscal picture is, panic-driven monetary policies portend to have even more dire consequences. We can expect rapidly rising prices and much, much higher interest rates over the next four or five years, and a concomitant deleterious impact on output and employment not unlike the late 1970s.

The author went on to attribute this rise in inflation and interest rates in a four to five year time frame to the Fed's purchase of assets and the resulting increase in the monetary base via its bank reserve component.

The piece was written by Arthur Laffer, and it was published on June 11, 2009, more than three years and five months ago. So far, the Fed's policies have not produced the dire results forecasted, although we are still a few months short of his four to five year time horizon. Yet, I hear virtually identical arguments these days as if our actual inflation and interest rate experience don't matter. I heard it most recently just now on financial radio from another well-respected economist.

The argument was the same: the Fed had created all these excess reserves, which have caused the monetary base to rise dramatically, and with all this money sloshing around, inflation is inevitable. First, neither excess reserves nor the monetary base (currency plus bank reserves) are money. The monetary base is potential money, potential high-powered money, but as long as its growth is primarily in reserves on deposit by the banking system at the Fed, it is not yet money. And, for that matter, I don't get where "sloshing around" comes from. This morning I hit a speed bump and the coffee in my cup holder sloshed, but bank reserves sitting idle in Fed accounts don't slosh.

One odd thing about the persistence of the "inflation is inevitable story" is that the people that keep repeating it despite evidence to the contrary also will tell you that the Fed's asset purchases do no good in stimulating the economy because it hasn't stimulated spending. Well, that's having it both ways that are contradictory. If spending isn't stimulated, how is inflation stimulated? Another element of the usual story is that the dollar will be trashed because of all this new non-existent money that is not being spent but will cause inflation. The dollar may yet decline, but so far the major trade-weighted dollar indexes are about where they were before the financial crisis.

The Fed's policies my yet cause major inflation and a sharp decline in the dollar, but it hasn't happened yet. And, it hasn't happened yet for reasons that are well known if ignored. As for the policies not doing any good either, we must keep counterfactuals in mind. I would argue that the Fed's actions in 2008 and 2009, in particular, averted a second Great Depression. Its policies since then probably helped, but may not have been essential, and may have some negative side effects.

If there has to be an "exit strategy," meaning that the banks' sudden aggressive use of their excess reserves causes real money to grow at inflationary rates and requires the Fed to "mop up" some of the excess reserves by selling off assets, then there is the potential for botching that process. But for now, what has already been done has not baked inflation into the cake.