It’s all about the money


Inflation has attracted little more than apathy from American political and economic leaders. Despite 21 months of inflation, measure by the consumer price index rising from 0.4% in April 2020 to 7.5%, its fastest pace in 40 years, the media focused on increases in various individual prices, not on the rate of depreciation of the value of money. Policymakers, who initially argued the surge was temporary, have only recently begun planning their action.

For the past four months or so, the Federal Reserve (Fed) has expressed the need to do something, but has largely postponed action until next month. Congress and President BidenJoe BidenUS tells UN Russia has list of Ukrainians ‘to kill or send to camps’: report Latest satellite images show shift in Russian military activity near Ukraine Biden agrees to meet Putin ‘in principle’ if Russia doesn’t invade Ukraine MORE seem indifferent. They waver on the decision to confirm three nominees for the Fed’s Board of Governors, giving Americans little or nothing on their views on monetary policy. Two of the three candidates appear to be focused on energy policy or income redistribution and have no record on monetary policy.

A recent survey from 12 experts on how to fight inflation provides more than 12 actions that could slow it down. Most of these actions seem to stem from popular suggestions about the causes of the surge: COVID-19, supply chain issues, corporate concentration and excessive profit margins, problems getting childcare or elders. President TrumpDonald TrumpRepublicans scramble to stop Greitens in Missouri Mace: I’ll win without Trump Walter Dellinger: A scholar and a mensch MOREthe trade war with China and others. There is no evidence that any of these factors have raised the general price level over the past year or earlier. No one mentions the unprecedented monetary expansion or the reverse. The magnitude of the monetary expansion indicates that the elimination of inflation will take several years. The downward adjustment of expectations, suggested by one expert, can only begin when the Fed demonstrates that it will act aggressively.

The Fed offered in January that he cannot separate his interest rate and balance sheet targets when he indicated that he will start raising the federal funds rate and end his rapid pace of balance sheet expansion in March. Higher interest rates reduce interest-rate-sensitive spending, slowing growth in monetary aggregates and total Fed assets. St. Louis Fed President has indicated that a strong reaction is needed to get the attention of financial markets and businesses – such as raising the fed funds rate by a full percentage point by July – suggesting to many observers support for a 50 hike basis points in March and again in July .

That probably won’t be enough. A faster rate of slowdown in the Total Fed Assets, including starting with a major one-time asset sale to withdraw much of its pandemic-related stimulus, is likely the next shoe to fall. The Fed should act more decisively — and quickly — to reduce the size of its balance sheet. The Kansas City Fed President recently checked in support such an approach.

The Fed’s average total assets more than doubled from $4.1 trillion during the last week of 2019 (week ending January 1, 2020) at $8.8 trillion during the last week of 2021 (week ending December 29, 2021). This extraordinary $4.7 trillion increase in the size of the Fed’s balance sheet exaggerates the inflationary pressure created by the asset explosion, as much of the asset purchases have not resulted in a measure of the stocks of the Fed that influence money called the monetary base. The Fed’s measure of monetary base grew by 87%, or $3 trillion, over the two-year period.

More than half of that rise, $1.7 trillion, came in the first five months of 2020, battling the shortest and sharpest recession since the Great Depression. As usual, the Fed was slow to see the end of the recession in May 2020 and the strong expansion it had triggered. As in the past, the Fed let this unprecedented monetary expansion continue for the next 19 months, fearing the worst was not over. The urgency is long gone, however, at least on the basis of broad performance measures such as the unemployment rate or real GDP. The Fed should respond appropriately and cut at least the first $2 trillion of this stimulus package before most of its inflationary consequences emerge.

When past temporary emergencies have occurred, the Fed has often quickly reversed course. For example, in anticipation of the millennium time change, potentially creating shutdowns of the banking system and the economy, the Fed took action in late 1999 to inject a relatively large amount of bank reserves and base money into the economy and quickly sold assets in January 2000 when the transition of the century turned out to be a non-event. The 9/11 terrorist attack caused our payment system to virtually shut down for about a week as flight suspensions wiped out the ability to move checks and temporarily inflated check deposits. In this case, the Fed injected massive reserves into the banking system to prevent banks’ reserves from becoming insufficient and, in about a week, removed those reserves as checks cleared and deposits surpluses were removed.

A third case occurred in 1980 when the Fed imposed credit control and in response, consumers and businesses reduced check deposits and built up currency holdings, sharply reducing monetary aggregates and causing, at the time, the sharpest and shortest (six-month) recession on record . When the credit control program came to an abrupt end in July 1980, foreign currency assets were redeposited in the banking system. Deposits and bank credit surged, causing an unusually large increase in money supply and real GDP in the second half of 1980.

It’s not too late to quickly withdraw most of the Fed’s balance sheet expansion, before the lion’s share of its effects on inflation materializes. A major reduction in the Fed’s balance sheet from March to May, selling off Agency mortgage-backed securities and Treasury securities, as well as allowing some of these assets to mature without replacement, could achieve this. A one-time reduction in the balance sheet and monetary base of about $2 trillion would be comparable to the Fed’s asset purchases and monetary base expansion during the comparable period in 2000.

This one-time sale of securities could eliminate most of the excess liquidity in the economy without noticeable effects on economic activity. More importantly, it could lead to a rapid and major pullback in inflationary expectations before most of the consequences of the liquidity injection materialize. The Fed could reinforce this adjustment by resetting the interest rate it pays on reserves to zero, against 0.15% currently. This would reduce the incentive for banks to hold their excess reserves with the Fed and facilitate their ability to expand credit, including buying the $2 trillion in securities the Fed currently holds. Despite the shrinking Fed balance sheet, banks and other financial institutions could increase their holdings of loans and credits by $2 trillion initially, and even more over time.

These policy changes, along with action on the federal funds rate, would quickly dampen inflationary expectations without hurting output and employment. But they are only the first step in the transition to price stability. Such actions could quickly cap current inflation. As of mid-year, the balance sheet would still have nearly $1 trillion of excess liquidity that would need to be eliminated to remove residual inflationary pressure from money creation over the past two years. This is still significant – more than 20% of projected base money by mid-year. A second phase of a more normal policy of moderation would be necessary to facilitate the return to price stability.

Without such timely action, however, inflation will likely accelerate and continue at an unacceptably high rate for years.

John A. Tatom is a member of the Institute of Applied Economics, Global Health and the Study of Business EnterprisesJohns Hopkins University and former head of research at the Federal Reserve Bank of St. Louis.


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