The Fed, money supply, interest rates, and inflation

This article by economist Edward Lotterman explains some of the dynamics in the Federal Reserve’s control of money supply and interest rates.

The monetary base consists of currency in circulation plus all bank reserves, that is, their deposits minus their loans. This is the variable the Fed controls through direct lending to banks or by open-market operations of buying and selling government bonds.

The Nov. 13 H.3 bulletin shows that the Fed increased this monetary base by 50 percent over the past 12 months, from $825 billion to $1.236 trillion. Such an increase is unprecedented in U.S. history.

The increase came through emergency Fed lending to sundry financial institutions. These went from $366 million in October 2007 to $15.4 billion one month later as the Fed went into panic mode. By early November 2008, such borrowing from the Fed reached $675 billion. This 44-fold increase in a year is extraordinary.

Over the past year, however, M2, the broad measure of the money supply, increased by only 7.4 percent, much less than the monetary base. What gives?

The answer is that the money supply depends not only on the monetary base, but also on how aggressively banks are lending. And while the Fed’s emergency interventions have ballooned the monetary base, banks have been contracting their lending sharply as part of the general deleveraging that is going on across the economy.

I’ve had trouble understanding why people have been worried inflation, rather than deflation. The price of everything seems to be going down: homes, gasoline, stocks, and everything covered by the consumer price index, which recently had its sharpest drop since 1947.

Lotterman’s very next paragraph helps explain better than anything I’ve read why some people are worried about the risk of inflation, not immediately, but during the recovery phase in the coming years:

The crucial question is whether, when the economy eventually improves, the Fed can shrink this vast pool of its own lending without negative consequences. If it doesn’t, such an increase in the monetary base would be inflationary in the long run. But it is hard to retract credit at just the right time when an economy is recovering from the effects of a credit crunch.

One explanation I’ve seen for inflation during a recovery is that the government tries to induce inflation to help people recover from debt, on the theory that you’re paying off debt with cheaper inflated dollars. Lotterman is explaining it in terms of simple overshoot – the government is afraid to turn off the money supply for fear of crashing the economy they resuscitated so they let the cheap money supply linger too long.