The Conundrum of Low Inflation Explained?
The conundrum of a low-growth, low-inflation environment combined with expanding, voluminous central-bank balance sheets has many scratching their heads. A recent stab at an explanation was given by Martin Feldstein, asking “Why is US inflation so low?”
Since 2008, Feldstein writes, the Fed has greatly expanded the money supply via its balance sheet, and yet all that time inflation, as measured by the Consumer Price Index, has remained at 1.5%. “The historical record shows that rapid monetary growth does fuel high inflation,” he says. “That was very clear during Germany’s hyperinflation in the 1920s and Latin America’s in the 1980s. But even more moderate shifts in America’s monetary growth rate have translated into corresponding shifts in the rate of inflation. In the 1970s, US money supply grew at an average annual rate of 9.6%, the highest rate in the previous half-century; inflation averaged 7.4%, also a half-century high. In the 1990’s, annual monetary growth averaged only 3.9%, and the average inflation rate was just 2.9%.”
Which is what makes the current disinflationary environment seem “so puzzling.”
Contrary to the reigning theories, which see central bank money creation as translating directly into money in circulation (which fear is what drove gold prices so high – and which, not having materialized, subsequently has precipitated gold’s decline), Feldstein denies the direct connection between Fed expansion and money-supply expansion. “The puzzle disappears when we recognize that quantitative easing is not the same thing as ‘printing money’ or, more accurately, increasing the stock of money.” Feldstein notes that it is not money that is being printed, but deposits that are being supplemented. These deposits are held by member banks. They are liabilities on the Fed’s balance sheet, corresponding to the Fed’s asset purchases.
And this has not translated into money growth at the consumer level, because, Feldstein argues, the Fed is paying interest on “excess reserves,” something which prior to 2008 it did not do. This has led member banks to maintain excess reserves, and indeed, these reserves have increased from less than $2 billion to $1.8 trillion. Feldstein says that this is money that member banks otherwise would have to lend out in order to make money from, but now, with the Fed’s interest payments, they don’t have to. They can just lean back and let the Fed’s interest payments roll in.
But this is to misconstrue the way the banking system functions. We have what is called a fractional-reserve system (something that I have elsewhere argued is a misnomer, but that is not relevant to the question at hand), and according to that system, a bank is allowed to lend out a multiple of the reserves it holds at the reserve bank. Reserves at the central bank, in our system, allow lending, rather than restrict it. Money held at the central bank is not money that otherwise would be lent out, but money that allows for even more money to be lent, indeed a multiple thereof. Banks, in fact, “create” that money, precisely through the “fractional-reserve” mechanism. So that “excess” reserves do not inhibit lending but allow it. The fact that they are “excess” is simply a function of a bank’s decision not to lend out as much money as it otherwise might.
It may be that, because of the change in Fed policy, banks now have more of an incentive to hold “excess” reserves than they used to. But it seems far-fetched that such an interest payment could outweigh the potential of interest payments on a multiple of that amount, which is what lending against those reserves would provide.
Alas, one must look further to find an explanation to this provocative conundrum.