Since 2008, the Federal Reserve has more than quadrupled the
adjusted monetary base. But this
new money has not resulted in massive consumer price inflation. There has certainly been significant
asset price inflation, particularly in stocks, but overall prices have not
exploded in correlation with the monetary base.
I see two main reasons that prices have stayed relatively
tame. The first reason is that the
velocity of money has been low.
Another way of saying this is that the demand for money has been
high. Money is changing hands less
frequently, thus keeping prices from being bid up.
The second main reason for tame price inflation is bank
reserves. The majority of the new
money created by the Fed has gone into excess reserves in the commercial
banks. So instead of loaning out
these new deposits, banks have been keeping them as excess reserves with the
Fed and earning a small .25% interest rate on the money.
I recently received the following comments and questions
regarding bank reserves:
“If one accepts the premise that most of the so-called
stimulus money is simply sitting as excess reserves propping up the so-called
‘too big to fail’ banks, what’s the harm if it stays there? If that money doesn’t get velocity, we
won’t see massive, commensurate price inflation.”
These are good questions. If the newly created money by the Fed simply goes into
excess reserves, does it matter?
The answer is “yes”; it still matters. While I think we are better off with
the high excess reserves as opposed to all of the new money being loaned out,
we would be much better off if the new money had not been created in the first
I think one mistake I have seen is people assuming that
there is no inflation if the new money goes into excess reserves. The fact that the new money is not
being loaned out simply means that the money is not multiplying. However, it is still new money.
That money sitting as excess reserves is money that has been
deposited in the banks and is available for people and businesses to
spend. Perhaps you don’t feel like
your checking account has gotten bigger over the last five years, but someone’s
checking account has gotten bigger.
All of the money sitting as excess reserves is not owned by the
banks. It is money that represents
So while having the new money go into excess reserves is far
less inflationary than if it had been lent out, it is still inflationary, even
if to a much lesser extent.
The other factor to consider is that, even though new money
has gone into excess reserves at banks, it is still misallocating
resources. This is what inflation
does. It misdirects resources,
including savings. The low
interest rates themselves send false signals to the market indicating that
people should save less.
The Fed is having a free lunch right now because it is
creating monetary inflation and not getting blamed too much for the bad
consequences. If we saw really
high consumer price inflation, then the Fed would likely take a lot of
blame. But if resources are being
misallocated and unemployment is staying higher because of the Fed’s actions,
most people do not perceive this.
Therefore, the Fed is doing great damage and getting away with it to a
As of right now, we are better off if the excess reserves
stay high. Otherwise, we would
likely see massive price inflation.
But we should not think that the Fed’s massive monetary inflation is not
inflicting great damage just because much of the new money is going into bank
reserves. It is still making us
poorer, even if more subtly.