Excess Reserves and Price Inflation

In my last post, I discussed the different factors of price inflation.  These factors are the money supply, the demand for money (also known as velocity), and fractional reserve lending.  Even this third thing really fits into one of the first two categories.

(It should be noted that production also has an effect on prices in the long run.  If there are increases in production, it can actually lead to a decrease in prices.  For the sake of this discussion, we are assuming that productivity and technology remain constant.)

One of the reasons that some people have been wrong in their prediction of imminent high price inflation is because of the massive excess reserves held by commercial banks.  When the Fed tripled the monetary base starting in late 2008, most of this newly created money went into excess reserves.  This has helped keep a lid on price inflation.

With that said, for today's post, I would like to discuss the possibility of high price inflation with excess reserves remaining high.

I have heard some people say that the Fed created new money for the banks (or something along these lines).  While part of the Fed's purpose of massive money creation in 2008 and 2009 was to save the banks, I want it to be clear on how the Fed creates money out of thin air.

I get the feeling that there is this perception among some people that the Fed just prints new money or creates digits out of thin air and puts it with the banks.  But this isn't really how it works most of the time.  The Fed is actually buying things in order to create new money.  Usually, the Fed buys government debt.  The Fed is basically creating new money (in the form of digits) to buy government bonds.  It is the government's spending that injects the money into the economy.  It should be said though that the Fed doesn't exactly buy the government's debt directly.  It goes through a broker, which is usually a large bank or financial institution.

The one exception to this is the Fed's purchasing of mortgage-backed securities.  The Fed did this unprecedented action starting in late 2008 and bought these at their original value.  Therefore, they paid a much higher price than would have been paid in the open free market.  Therefore, the Fed's purchases of these junk assets really was a direct bailout of the banks and financial institutions.

It needs to be understood though that the Fed has still created new money out of thin air, even if this new money is being held by banks as excess reserves.  It represents money in someone's account.

If an individual were to buy government bonds with money he had saved, then this does not affect the supply of money.  Money is being transferred from the person's account who buys the bonds to the Treasury Department (whether directly or indirectly).  So when the government spends this money, there is no additional money in circulation.

But if the Federal Reserve buys government bonds, it is creating new money to do this.  The Fed does not actually produce and save anything.  It is just creating digits out of thin air and transferring them from its account to the account of the Treasury Department.  It represents an increase in the money supply.

So even though this is not exacerbated by fractional reserve lending because of an increase in excess reserves, it is still an increase in the money supply.  It is not the bank's money that is just sitting there.  It represents people's checking accounts or those of businesses.  It is from new money that has already been spent by the government.  (I suppose state and local governments could have a rainy day fund that might be a small part of this.)

Any way you slice it, this new money is there to be spent, even if it is not being lent.

The point here is that we could still see severe price inflation even if excess reserves remain high.  If the Fed keeps buying government debt like crazy, there will be consequences, and it will eventually be in the form of higher prices and a lower standard of living.

There will also come a time where if the money supply increases enough, then velocity can, and probably will, change rather quickly.  Once people perceive that prices are going up faster and they are losing purchasing power by having their money sitting in a checking account, then they will start to spend it.  Some will spend it foolishly on certain consumer goods.  Others will spend it to protect their wealth.  It may be in stocks, real estate, gold, fine art, or any number of other commodities.

So while excess reserves are certainly a major factor in the discussion of price inflation, it is important to know that we can still see high price inflation even with excess reserves remaining high.  If the Fed keeps monetizing government debt, there will be a day of reckoning.