*I thought you might be interested in my recent piece on Fed policy in
Project-Syndicate.com*
*
*
*Marty*
Project Syndicate
Fed Policy and Inflation Risk
March 2012
By MARTIN FELDSTEIN
CAMBRIDGE During the past four years, the United States Federal Reserve
has added enormous liquidity to the US commercial banking system, and thus
to the American economy. Many observers worry that this liquidity will lead
in the future to a rapid increase in the volume of bank credit, causing a
brisk rise in the money supply and of the subsequent rate of inflation.
That risk is real, but it is not inevitable, because the relationship
between the reserves held at the Fed and the subsequent stock of money and
credit is no longer what it used to be. The explosion of reserves has not
fueled inflation yet, and the large volume of reserves could in principle
be reversed later. But reversing that liquidity may be politically
difficult, as well as technically challenging.
Anyone concerned about inflation has to focus on the volume of reserves
being created by the Fed. Traditionally, the volume of bank deposits that
constitute the broad money supply has increased in proportion to the amount
of reserves that the commercial banks had available. Increases in the stock
of money have generally led, over multiyear periods, to increases in the
price level. Therefore, faster growth of reserves led to faster growth of
the money supply and on to a higher rate of inflation. The Fed in effect
controlled or sometimes failed to control inflation by limiting the
rate of growth of reserves.
The Fed began an aggressive policy of quantitative easing in the summer of
2008 at the height of the economic and financial crisis. The total volume
of reserves had remained virtually unchanged during the previous decade,
varying between $40 billion and $50 billion. It then doubled between August
and September of 2008, and exploded to more than $800 billion a year later.
By June of 2011, the volume of reserves stood at $1.6 trillion, and has
since remained at that level.
But this rise in reserves did not translate into rapid growth of deposits
at commercial banks, because the Fed began in October 2008 to pay interest
on those reserves. Commercial banks could place their excess funds in
riskless deposits at the Fed, rather than lending them to private
borrowers. As a result, the money supply has grown by only 25% since 2008,
despite the 40-fold increase in reserves since that time.
During the past year, the Fed has further increased the liquidity of the
banking system and of the American economy by a strategy called
Operation Twist, buying $400 billion of long-term securities in exchange
for short-term Treasury bills. The banks that hold these Treasury bills can
sell them at any time, using the proceeds to fund commercial lending.
The massive substitution of reserves for longer-term securities during the
period of quantitative easing, and of Treasury bills for long-term
securities in Operation Twist, has succeeded in reducing long-term interest
rates. The combination of low interest rates at every maturity and the
substitution of short-term securities for longer-term assets has also
succeeded in raising share prices.
But it is not clear that the lower interest rates and higher share prices
have had any significant effect on real economic activity. Corporations
have a great deal of liquidity, and do not depend on borrowing to invest
more in plant and equipment. Housing construction has not revived, because
house prices are
file:///I:/feldstein/projectsyndicatemarch2012.html 4/2/2012
Fed Policy and Inflation Risk Page 2 of 2
falling. Consumers temporarily increased their spending in response to the
increase in the stock market at the end of 2010, but that spending has
recently been much more sluggish.
The risk is that the commercial banks could always decide to start using
those excess reserves, forgoing the low rate of interest paid on deposits
by the Fed (only 0.25%) and lending those funds to firms and households.
Those loans would add to deposits and cause the money supply to grow. They
would also increase spending by the borrowers, adding directly to
inflationary pressures.
When the economy begins to recover and companies have the ability to raise
prices, the commercial banks will want to increase their lending. This will
be welcome, as long as it is not too much or too fast. The Fed will
appropriately want to limit the expansion of bank lending. This is what the
Fed used to talk about as its exit strategy. Essentially, it would mean
raising interest rates on the deposits at the Fed and allowing interest
rates more generally to rise. If this is done in a timely way and on an
adequate scale, the Fed will succeed in preventing the current vast
liquidity from generating higher inflation.
Here is what worries me: the structure of US unemployment is very different
in the current downturn than it was in the past. Nearly half of the
unemployed have been out of work for six months or longer. In the past, the
corresponding unemployment duration was only 10 weeks. So there is a danger
that the long-term unemployed will be re-employed much more slowly than in
previous recoveries.
If the unemployment rate is still very high when product markets begin to
tighten, the US Congress will want the Fed to allow more rapid growth in
order to bring it down, despite the resulting risk to inflation. The Fed is
technically accountable to Congress, which could apply pressure on the Fed
by threatening to reduce its independence.
So inflation is a risk, even if it is not inevitable. The large volume of
reserves, together with the liquidity created by quantitative easing and
Operation Twist, makes that risk greater. It will take skill as well as
political courage for the Fed to avoid the rise in inflation that the
existing liquidity has created.
Martin Feldstein, a professor of economics at Harvard, was formerly
Chairman of President Ronald Reagans Council of Economic Advisors and
President of the National Bureau for Economic Research.
Copyright: Project Syndicate, 2012. www.project-syndicate.org
Received on Tue Apr 03 2012 - 17:18:36 EDT
