Where’s all that inflation?

Where’s all the inflation?

Since the onset of the financial crisis of 2008, the US Federal Reserve (America’s central bank) has been flooding the market with cash. The Fed controls the monetary base —- that’s currency in circulation plus deposits held by banks in the twelve regional Federal Reserve banks (those deposits can be converted into currency at a moment’s notice). The monetary base has tripled in just five years. http://research.stlouisfed.org/fredgraph.png?g=kH7 . This sure looks like printing press money. Some senators and many opinion-leaders claim that a tsunami of inflation cannot be far away. Too much money chasing too few goods.

How does the Fed create the monetary base? It buys debt instruments for cash. It usually buys US Treasury bills. Recently, in the move known as quantitative easing , it’s been buying longer term Treasury debt and mortgage debt. It pays in cash (since the Fed is uniquely empowered to issue Federal Reserve Notes). The monetary base grows when the Fed buys more assets for its portfolio and pays in newly created cash. In this way, by making money easily available and buying up outstanding debt, the Fed plans to keep long term interest rates low to encourage business investment, housing purchases and construction.

Will this policy result in galloping inflation? Classical style economists, Chicago school monetarists, and Keynesians have been fighting this battle since the late 1930s. Recent experience may prove decisive (a fond hope; seldom do we get decisive evidence in economics).

The quantity theory of money is very well adapted to the 19th century, when real money was gold. Double the amount of gold around and you double the nominal amount of economic activity, some of it price inflation. That’s what William Jennings Bryan’s ‘Cross of Gold’ speech was about : deflation associated with a relatively constant gold supply in a growing economy

Modern money is paper and accounting entries convertible to paper. The only backing is the government’s promise to accept it in payment of taxes.

So the fear of upcoming inflation is based on the rapid growth of the monetary base. All of that money sloshing around must generate inflation. Except that it does so only if it generates economic activity and shortages of labor or output (the Keynesian view). So far the Keynesian view has been the more reliable guide to reality. Inflation has remained under 2% annually throughout the period of intense monetary base growth.

Copyright 2013 Ross M. Starr



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