The Inflation Risk Around the Corner
Monday, 20 February 2012
Rough estimates suggest that inflation could rise as high as 15 percent by late 2013 or 2014 if the Federal Reserve is unable to drain off more than 25 percent of the reserves in the banking system.
That’s the best estimate based on a variety of forces that traditionally drive inflation.
Much can change the risk of inflation, from the impact of the European crisis on the American recovery to domestic tax increases and cuts in government spending. But no matter what, the single most important driver of a rise in the general price level is the relationship of the money supply to economic activity.
Right now the growth rate of the money supply is poised to accelerate. Since the economic meltdown began in 2008, the Fed has pumped an extraordinary amount of money into bank reserves. Now that money is beginning to move.
When growth in the money supply is not proportional to economic growth, inflation inevitably follows. That’s been common knowledge since at least the 16th century, when gold and silver from the New World caused an inflation in Spain known as “the price revolution.”
The most widely quoted official estimate of U.S. inflation—the consumer price index—put the 2011 inflation rate at 3.1 percent. This is a point higher than the desired target rate of 2 percent recently announced by the Fed.
There is a lag between money supply growth and inflation, which most monetary economists compute as being somewhere between 1.5 and 2 years. The most recent inflation rate came about in response to the growth of the money supply in mid-2010. During the second and third quarters of that year, M2—a frequent measure of the money supply that includes currency, checking accounts, savings accounts, money market mutual funds, and traveler’s checks—grew at an average rate of 3.5 percent.
Although the recession officially ended in June 2009, the Fed has continued to pour money into banks in an effort to stimulate the economy. In 2011 alone, adjusted bank reserves increased at a compounded annual rate of 47.1 percent. In the first half, reserves increased by 187.9 percent. These rates of growth are without precedent. To the extent that the bank reserves might make it into the hands of businesses and consumers, the risk of higher inflation rises.
Until recently, the reserves weren’t going anywhere. Banks have been reluctant to make the loans that would put the reserves into circulation. The banking industry was taken to task for making risky loans before the meltdown that produced weak balance sheets. What’s more, beginning in October 2008, the Fed started paying interest on reserves held at Federal Reserve Banks. The move was apparently designed to help buoy bank balance sheets, but it also made it profitable for banks to forego lending in favor of the low-risk profit provided by the Fed’s interest payments.
Banks are currently holding about $1,500 billion in excess of the roughly $100 billion in reserves required by the Fed—15 times more than they need. Historically, banks have held only 1 or 2 percent over required reserves. They make profits primarily by lending out money, not by keeping the money on hand.
The pace of bank lending is on the rise. The volume of commercial and industrial loans from all commercial banks fell throughout the recession and bottomed out in October 2010 at roughly $1.2 trillion. Since then, these loans have increased by 11.3 percent.
As the recovery progresses, bank loans will further increase.
Even at the current rate of lending, the money supply has been growing faster than the economy. In December 2011, M2 grew at a year-to-year rate of about 10 percent. GDP, during this period, grew at 2.8 percent. Assuming no changes to the financial or payments system, this translates to a potential inflation rate of 7.2 percent (10 percent less 2.8 percent).
This is basic monetary policy arithmetic. But it only considers money currently in circulation. Given the volume of bank reserves ready to enter the money supply, more money is certain to enter circulation, making the inflation risk substantially higher.
Every dollar put into circulation through a loan adds more than a dollar to the money supply. Here’s how it works. Banks make loans using reserves. Borrowers spend the loaned money, and those who receive the payments deposit them in their banks. Their banks have now increased reserves and expand their lending. And so it goes. This lending-relending process is called the bank multiplier or just the multiplier.
Chart 1 shows the relationship between M2 and the monetary base. The monetary base is part of M2, made up of reserves plus currency in circulation. The base is the core of the money supply and is expanded into the larger money supply through the multiplier. The data in the chart is presented in log terms. Essentially, the distance between the two curves is the multiplier.
For about a decade before the autumn of 2008, when the U.S. economy went into free fall, the multiplier stood steady at the 8-9 range. That means that every new dollar in the monetary base resulted in an $8 to $9 increase in the money supply.
Bank lending dried up following the financial meltdown and the onset of recession. With that, the multiplier fell to roughly the 3.5-4 level.
At the same time, the Fed made a decision to ensure liquidity for transactions in order to encourage the recovery. To do so, it boosted the monetary base through the expansion of bank reserves and currency, at whichever rate was required to keep M2 expanding more or less at the same rate as it had been. Between October 2008 and December 2011, the Fed expanded the base by $1,453 billion, to $2,595 billion. By February, it had more than doubled.
The problem is that as the recovery progresses, the multiplier will move back toward normal levels, and the money supply will expand. Because of this, inflation could grow greatly in excess of the rule-of-thumb projection of 7.2 percent derived from 2011 data.
Fed Chairman Ben Bernanke says the Fed is working on methods to drain the excess reserves from the system and lessen the risks of high inflation. But there are reasons to doubt the Fed’s ability to do so.
One reason is historical. No central bank has ever attempted to drain such massive excess reserves from a banking system. In addition, the Fed also must walk a delicate line. Draining too much money from the economy could raise interest rates and create liquidity problems, threatening the fragile recovery. Draining too little could lead to inflation.
Our projection of a potential inflation rate of 15 percent by late 2013 and early 2014 is based on conservative assumptions. As the recovery progresses, the multiplier should rise to at least 8, the low end of its pre-2008 range. This will result in substantial money creation. Bernanke has provided repeated assurances that when this happens, the Fed will act to address this problem.
Among the actions the Fed may take is the direct reduction of reserves through open market operations. The Fed could also require banks to hold more reserves through changes in reserve requirements and induce banks to hold more reserves by raising the interest rate the Fed pays on reserves.
The purpose of this analysis is to offer a sense of the magnitude of the possible risk of inflation, as well as provide a framework for evaluating future risk in a rapidly changing economic environment. To accomplish this, we made an assumption. We chose a 25 percent reduction of the reserves in the banking system as a reasonable estimate of what the Fed could accomplish to lessen the monetary supply as the economy improves.
According to that estimate, the interplay between a higher multiplier and the Fed action to keep money out of the economy will yield $3,900 billion of new M2 dollars. This is an increase of roughly 40 percent, or almost five and a half times the growth rate in 2011.
Because of the potentially huge increase in the money supply, inflation projections become more challenging. Changes in the financial and transactions systems are sure to occur.
International experience, however, can provide a clue to what might happen. Chart 2 shows the relationship between M2 growth (in percent) and inflation rates across 103 countries over 10 years. Based on the relationship, a 40 percent increase in M2 would result in an inflation rate of about 15 percent.
Precision in estimates of future inflation—or any other economic measure—are always made difficult by the number of variables that are still in play.
Changes in fiscal policy—more taxes or less spending—could depress the money multiplier by slowing the growth of economic activity and bank lending.
Money expansion would also slow if the Fed was able to drain more than 25 percent of reserves from the system or could entice banks to hold more reserves rather than make loans. Any of these would reduce the level of inflation or postpone inflation risks.
The crisis in Europe, by contrast, could heighten inflation risks and levels in a number of ways.
Currency swaps with the European Central Bank could lead to even more money creation. The swaps are intended to prop up the European economy and help insulate the American recovery from immediate damage. But if the ECB cannot repay the swaps in full, the Fed might make up the loss by creating new dollars. This money creation could be inflationary to the U.S.
Despite the many uncertainties, one fact remains: An enormous wall of money has built up in the banking system. Should it find its way into the general economy at pre-recession rates, the U.S. is in for quite a ride.