Alan Reynolds: Fed can’t reduce money supply in time to stop inflation

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Alan Reynolds: Fed can’t reduce money supply in time to stop inflation

Monday, February 23rd, 2009 | Economics |

I’ve been noting that the Federal Reserve’s unprecedented increase in the money supply will lead to inflation. Federal Reserve Chairman Ben Bernanke is claiming that just as soon as the economy starts to recover he’ll pull back the money supply Wizard of Oz style and - voila! - no inflation.

Alan Reynolds questions Bernanke’s claims:

If inflation catches the Fed by surprise, are they really “able to quickly reverse the actions,” as Bernanke says? How could they do that?The Fed could certainly raise the interest rates on bank reserves — the fed funds and discount rate — which is how it makes money and credit tighter in normal times. But that rationing device would not prove so effective in times like these, because banks are already sitting on a mountain of untapped reserves. Besides, once expected inflation has begun to rise, the Fed has usually moved rates up in 25-basis steps — increases so small that perceived real interest rates can continue to fall even as nominal rates rise.

To literally reverse the actions that doubled its assets since last September, the Fed would have to sell nearly a trillion dollars worth of IOUs. Unfortunately, they don’t have nearly that many Treasury securities to sell. And even if the Fed were willing sell off all of its Treasury bills and bonds, the remaining backing for Federal Reserve notes would be little better than junk bonds. Meanwhile, private and agency securities acquired since last September must be very hard to sell — or else the Fed would not have felt obliged to buy them.

The Fed’s System Open Market Account at the Federal Reserve Bank of New York holds $39.4 billion in inflation-protected Treasury bonds — more than twice its $18.4 billion stash of short-term Treasury bills. Are they trying to tell us something?

Point 1 is that you shouldn’t believe Bernanke when he claims he can snap his fingers and put the kibosh on the inflationary dragon.

Point 2 is that Reynolds notes something I hadn’t considered.

To assume, as Bernanke does, that inflation cannot possibly accelerate until “the economy begins to rebound and financial markets stabilize” is to assume stagflation is impossible, though 1973-75 and 1979-82 proved otherwise.

I keep saying that we won’t have serious inflation until after the recovery begins, that the recovery can’t begin until we hit bottom, and that we’re a long way from hitting bottom. Sounds pretty pessimistic, doesn’t it? Thing is, just like Bernanke I wasn’t considering the possibility of stagflation (a stagnant economy combined with the inflation of a red-hot economy). If that happens things could be even worse than I imagined. Dangit.

P.S. In another post Reynolds poo poos the jump in producer price inflation I mentioned last Monday.

Tags: bernanke, inflation, stagflation, the fed

4 Comments to Alan Reynolds: Fed can’t reduce money supply in time to stop inflation

persimmon
February 23, 2009

Banks are sitting on a mountain of untapped reserves? Some of them seem to be sitting in a pit of radically leveraged losses. It seems to me that banks are still trying to untangle the horrible mess of CDOs and don’t yet know how their nominal assets square with their real capital holdings.

Les Jones
February 23, 2009

“Banks are sitting on a mountain of untapped reserves?”

Yep. The government gave them tons of Treasury money during TARP, followed by the Federal Reserve’s loans. The banks are sitting on the money. That’s why there’s been so much turmoil about finishing the other $350 billion or so left in TARP - politicians gave it to the banks to loan out and instead the banks sat on it.

“Some of them seem to be sitting in a pit of radically leveraged losses. It seems to me that banks are still trying to untangle the horrible mess of CDOs and don’t yet know how their nominal assets square with their real capital holdings.”

Yep. That’s one of the reasons they’re sitting on the shiny new credit the government gave them rather than using it. They may need it when their loans start going bad and they have to mark that $500,000 California mortage down to the $250,000 it’s actually worth now. Until they foreclose they can pretend it’s still worth $500,000.

persimmon
February 23, 2009

Right. In order for the inflation scenario to play out, you have to assume the TARP mountain is taller than the CDO pit is deep. Estimates I’ve seen suggest the pit is a good bit deeper.