With the size of the Federal Reserve’s balance sheet nearly doubling from around $3.7 trillion to over $7 trillion within the last year, some are asking if and when we will finally see inflation. To put the problem in perspective, the size of the Federal Reserve’s balance sheet was about $900 billion before the financial crisis took hold in September 2008. In the span of only a few months, it grew to over $2.2 trillion. It would double again by 2015, reaching a peak of $4.5 trillion before tapering to $3.5 trillion before the more recent downturn.
Today, the Fed’s balance sheet stands at nearly $7 trillion. It has increased by a factor of 8 in just over a decade. And, yet, annualized inflation over the same period has generally fallen below the Fed’s stated two-percent target. Inflation seems to be the shoe that just won’t drop.
George Selgin has reflected on the spectre of inflation under these circumstances. “But if denying any risk of future inflation is unwise,” he writes, “so is exaggerating that risk, or claiming that it’s imminent when it isn’t.”
The worst case outcome is exactly that: a worst case outcome. Absent a crisis that radically transforms the existing financial system, there is good reason to expect that the trend of low inflation will continue in spite of the apparent monetary easing by the Federal Reserve.
Monetarist and Keynesian Monetary Policy
The rate of inflation is low and will likely remain low absent a fiscal crisis. To understand this counterintuitive result, it is necessary to consider how different types of monetary policy are thought to affect economic activity. I make a distinction between monetarist and Keynesian approaches. The monetarist approach to monetary policy attempts to impact the level of total expenditures by changing the quantity of money in circulation. The Keynesian approach, in contrast, attempts to influence total expenditures by movement of the interest rate.
It is not that policy implemented using the monetarist approach does not influence interest rates or that policy implemented using the Keynesian approach does not influence the quantity of money. Rather, each strategy targets one or the other variable, meaning that changes in the variable not targeted are a second order effect of a given monetary policy. The current monetary regime largely relies upon the Keynesian approach, but policy makers are especially mindful of the monetarist second order effects. In the current monetary regime, the effect of consequent increases in the quantity of money in the financial system are systematically muted.
While monetarist policy can take on a variety of forms, it is most easily understood in terms of the quantity of money. If the central bank increases (decreases) the quantity of money in circulation through the purchase (sale) of assets, usually bonds, the average level of investors’ cash balances will increase (decrease). If investor preference to hold money is stable, then the new cash balances acquired in the course of monetary expansion will be invested until the desired level of cash balances is reached by each investor. This increased investment leads to an increase in real incomes as long as expectations of inflation have not included the full effect of monetary expansion. Hence, the monetarist approach influences the total level of expenditures by managing the quantity of money.
When monetary policy is implemented using the monetarist approach, nominal and real interest rates may react negatively to the change in the quantity of money in the short term, falling in the case of monetary expansion. But nominal rates will rise in the long run, as the monetary expansion is reflected in expected inflation, leaving real rates unaffected. These changes in interest rates are a second order effect of policy, though. If the central bank adopts a monetarist approach, the best it can do is maintain low and stable rates of inflation while offsetting short-run business fluctuations with emergency liquidity provisions that are self-reversing.
John Maynard Keynes doubted that monetary expansion, on its own, could reliably boost the level of total expenditures. He believed individuals would simply allow their cash balances to increase as the monetary authority engaged in expansion during especially traumatic economic downturns.
In his discussion of interest rates in the General Theory, Keynes emphasized the link between marginal returns to investment in capital and the interest rate. Investors will borrow money so long as they expect that the rate of return on their investment to be greater than the interest rate. It follows that, if the economy is in recession, one way to boost the total level of expenditures is to lower interest rates so that investors will take on new, formerly unprofitable, projects.
If a low interest rate policy is successful, the level of production improves across the economy and total expenditures return to normal levels. Keynes assumed that increases in expenditures would draw resources not actively being utilized into productive activities before the level of prices would rise. Since interest rates are targeted in light of changes in the level of productivity, the inflationary effects of monetary policy could be effectively ignored.
The Keynesian approach to battling a recession loses its effectiveness as interest rates approach 0%, or perhaps at a modestly negative level of nominal rates known as the effective lower bound. Keynes did not promote a negative interest rate policy with respect to this problem. Rather, he recommended fiscal expansion to kickstart an economy that has experienced severe contraction.
Modern Monetary Regimes
While no monetary regime is perfectly described by either of these two approaches, it is appropriate to describe a regime in light of its emphasis. From the 1980s to the mid-2000s, Paul Volcker and Alan Greenspan emphasized the need to manage monetary growth in order to moderate inflation. As such, their approach was primarily monetarist in nature, even if policy during these years was largely expressed in terms of interest rate policy.
Volcker targeted the growth of monetary aggregates in his early years. However, targeting monetary aggregates did not seem to promote the intended effect of stabilizing inflation. Policy in Volcker’s later years turned to interest rates as the relevant policy lever, but the goal was still to moderate inflation.
Greenspan’s monetary support in the face of macroeconomic fluctuation was also sufficiently monetarist. He provided general liquidity for limited periods during times of trouble, but the monetary expansions were self-reversing.
The Volcker-Greenspan policy regime was not purely monetarist, to be sure. They applied monetarist insights concerning the relationship between money and inflation. But they used interest rate targeting to maintain low and stable inflation. Under Volcker and Greenspan, interest rates rose and fell in sync with changes in the rate of inflation and the level of resource utilization by productive enterprise. Their commitment to this policy regime stabilized inflation expectations. And, in doing so, they lived up to Milton Friedman’s prescription that monetary policy be predictable and maintain a stable rate of inflation.
The (Ben) Bernanke-(Janet) Yellen-(Jerome) Powell policy regime that followed has taken a much more Keynesian approach. It has reduced monetarist concerns of inflation, enabling the Fed to allocate credit to a much greater extent and pursue policies traditionally limited to the fiscal authority.
In October 2008, the Bernanke Fed began paying interest on reserves. The result was a fundamental change in the Fed’s operating regime. Under the new regime, which would be carried on under Yellen and Powell, the Fed automatically offsets the inflationary effects of its asset purchases by paying a sufficiently high rate of interest on reserves. The Fed can then target the general level of interest rates without generating inflation.
The new regime also allows the Federal Reserve to provide significant levels of support for particular industries and types of debt. Major purchases of mortgage-backed securities, for example, shift resources toward home construction, increasing the level of investment in the industry and lowering rates paid on mortgages. Major purchases of long-term debt, more generally, push down yields on long-term bonds relative to yields on short-term bonds, encouraging investment in lengthier projects.
The Fed would have much less control over the allocation of credit and shape of the yield curve if it were not suppressing inflation through its policy of paying interest on reserves. The monetarist concern is real: a massive expansion in the Fed’s balance sheet would result in significant inflation if the Fed were not sterilizing its asset purchases. With the inflationary effects of monetary policy muted, however, Fed officials face little in the way of a binding constraint on policy decisions. They are largely free to follow their more Keynesian predilections.
The Fed appears to be making the most of its newfound freedom. It is exercising an unprecedented level of influence over economic activity. At the behest of Congress, it has opened new facilities far afield of its traditional mandate. There is still some risk that the Fed will lose control and inflation will get out of hand. But there is a much bigger risk that the Fed will misallocate credit, reducing long run economic growth in the process.
[Note: I am grateful to Jeff Hummel for providing helpful suggestions.]