Inflation fears

Is it reasonable to worry about inflation in the current environment?

With unemployment likely to stay near 10% for the next year, it is hard to imagine wage inflation returning any time soon. In October I illustrated a simple Phillips curve relation that could be used to forecast the inflation rate over the next two years as a function of the realized inflation rate over the previous five years along with the current unemployment rate. The figure below updates that forecast using the December unemployment numbers. The relation is still calling for deflation, not inflation, over the next two years.



Top panel: Black line is the value of subsequent average 2-year inflation rate (πt+8) corresponding to each indicated date t Blue line is the predicted value from the dynamic regression for each indicated date t. Bottom panel: unemployment rate as of last month of indicated quarter t.
inf_forecast_jan_10.gif



Downward pressure on rents is another factor that makes a surge in the large owner-equivalent-rent component of the CPI unlikely. Why then would anybody expect an immediate resurgence of inflation?

Greg Mankiw offers this analysis:

One basic lesson of economics is that prices rise when the government creates an excessive amount of money. In other words, inflation occurs when too much money is chasing too few goods. A second lesson is that governments resort to rapid monetary growth because they face fiscal problems. When government spending exceeds tax collection, policy makers sometimes turn to their central banks, which essentially print money to cover the budget shortfall….

The federal government’s budget deficit was $390 billion in the first quarter of fiscal 2010, or about 11 percent of gross domestic product. Such a large deficit was unimaginable just a few years ago. The Federal Reserve has also been rapidly creating money. The monetary base– meaning currency plus bank reserves– is the money-supply measure that the Fed controls most directly. That figure has more than doubled over the last two years. Yet, despite having the two classic ingredients for high inflation, the United States has experienced only benign price increases….What gives?

Part of the answer is that while we have large budget deficits and rapid money growth, one isn’t causing the other. Ben S. Bernanke, the Fed chairman, has been printing money not to finance President Obama’s spending but to rescue the financial system and prop up a weak economy.

I see this last issue a little differently from Greg. I would emphasize that there are a number of components that could contribute to future fiscal deficits. These include not just the standard concerns about whether taxes will be raised sufficiently to cover growing entitlements– and that by itself is of course a huge issue– but also prospective expenditures needed to make good on the government’s guarantees of the obligations of institutions such as Fannie, Freddie, and the FDIC, whose notional commitments exceed the entire federal debt held by the public. The business of making such loan guarantees is by its nature a decision of fiscal as opposed to monetary policy. But having the Fed absorb credit risks that private actors will not is the essence of the new monetary policy adopted by the Federal Reserve over the last year and a half. I furthermore am persuaded that the Fed assumed these obligations precisely because the U.S. Congress was unwilling to authorize such actions as an explicit fiscal act. As I wrote in my contribution to the recent book, The Road Ahead for the Fed:

If I were the chair of the Federal Reserve, I would want to be asking, “why was I invited to this party?” The answer unfortunately appears to be, “because you’re the one with the deep pockets.” That the Fed should find itself in a position where Congress and the White House are viewing its ability to print money as an asset to fund initiatives they otherwise couldn’t afford is something that should give pause to any self-respecting central banker.

Greg Mankiw’s source of reassurance is thus the cause of my personal anxiety. I think the separation between monetary and fiscal policy has become increasingly blurred. I maintain that the keys to preventing a resurgence of inflation in the U.S. are (1) credible and responsible commitment from Congress that it is not going to allow the debt-to-GDP ratio to continue to balloon over the next decade, and (2) a return of the Federal Reserve to a primary focus on controlling the money supply rather than trying to target particular yield spreads.

And what about the monetary expansion we’ve seen already? Here is Greg’s analysis:

As the economy recovers, banks may start lending out some of their hoards of reserves. That could lead to faster growth in broader money-supply measures and, eventually, to substantial inflation. But the Fed has the tools it needs to prevent that outcome.

For one, it can sell the large portfolio of mortgage-backed securities and other assets it has accumulated over the last couple of years. When the private purchasers of those assets paid up, they would drain reserves from the banking system.

And as a result of legislative changes in October 2008, the Fed has a new tool: it can pay interest on reserves. With short-term interest rates currently near zero, this tool has been largely irrelevant. But as the economy recovers and interest rates rise, the Fed can increase the interest rate it pays banks to hold reserves as well.

Here again I differ from Greg. I see no conceptual distinction between short-term T-bills issued by the Treasury and interest-bearing reserves created by the Fed. Both represent liabilities from the government that must be repaid with interest. The Treasury should not assume it can always roll over an increasing volume of debt simply by issuing more debt, nor should the Fed assume that it can always persuade banks to continue to hold a trillion dollars in excess reserves simply by exercising its one true power– the ability to print more money. The value of the new Federal Reserve liabilities ultimately will be determined by the long-term fiscal soundness of the U.S. government.

Let me nevertheless again emphasize that I don’t see these dynamics playing out in the form of a near-term surge in inflation, for the reasons I spelled out in the beginning. Inflation is not something you should be afraid of for 2010. But what we need is a convincing commitment from the government to both near-term stimulus and longer-term fiscal responsibility in order to be assured that it’s not a concern over the next decade.

And that’s not what I’m seeing from the U.S. Congress.

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50 thoughts on “Inflation fears

  1. Get Rid of the Fed

    “The Federal Reserve has also been rapidly creating money. The monetary base– meaning currency plus bank reserves– is the money-supply measure that the Fed controls most directly.”

    I hope you can explain to everyone why they chose bank reserves and not currency. I want to see that.

  2. Get Rid of the Fed

    “Here again I differ from Greg. I see no conceptual distinction between short-term T-bills issued by the Treasury and interest-bearing reserves created by the Fed. Both represent liabilities from the government that must be repaid with interest.”

    Some people can claim that interest-bearing reserves created by the Fed are actually gov’t debt in disguise (since the gov’t as it is now won’t let the fed fail) with a term of overnight. Plus, why should the gov’t (taxpayers) back up liabilities from the fed that help their banking buddies?

  3. Get Rid of the Fed

    “The Treasury should not assume it can always roll over an increasing volume of debt simply by issuing more debt, nor should the Fed assume that it can always persuade banks to continue to hold a trillion dollars in excess reserves simply by exercising its one true power– the ability to print more money.”

    IMO, you should NOT use the phrase “print more money”. IMO, the fed can print currency or can “print” bank reserves. Using “print more money” can confuse people.

  4. Don the libertarian Democrat

    “I maintain that the keys to preventing a resurgence of inflation in the U.S. are (1) credible and responsible commitment from Congress that it is not going to allow the debt-to-GDP ratio to continue to balloon over the next decade, and (2) a return of the Federal Reserve to a primary focus on controlling the money supply rather than trying to target particular yield spreads.”
    I keep recommending this essay, because the point of it is to do just that with a series of constraining and reinforcing policies:
    Milton Friedman “A monetary and fiscal framework for economic stability”
    I’m not arguing that we need to follow his plan exactly, but it does provide a basis for resolving these issues.

  5. Darko Oracic

    Have you heard of “long and variable lags” in monetary policy effects? It takes about a year or more to see a peak effect on real GDP growth and about two years or more to see a peak effect on inflation. So yes, there will be no high (core)inflation in 2010, but high inflation later on is inevitable. Any monetary tightening to prevent that will be too late.

  6. Plan B Economics

    In theory I agree with Greg’s article. However, reality might be a bit different.
    The Fed CAN sell MBS’s and raise rates on bank reserves, for example, if inflation starts heating up. But will it do so if unemployment is near 10%?
    The inflation story is not about the Fed’s ability to control inflation, but its willingness to control inflation.

  7. ppcm

    Freedom is not about having a good master, but to have none. Cicero
    One may have to read the depraved translation of the above statement as follows;
    Central banks are independent (ECB) or deemed to be(Fed) and yet they rescued the recurrent fiscal government spendings.
    The states bonds auction regulations are stating that liquidity and primary dealers dis-hoarding are the cornerstones of these markets and yet primary dealers have been and are encouraged to do otherwise.
    Basle 1, B2, B+n prudential ratios dissuade risk concentration,excess leverage on capital funds and yet no or only few banks are and were in compliance.
    When derivatives have proved to be an instrument of leverages and prices distortion, many public voices were broadcasting the outrage.They may have found that compliances with prudential ratios including derivatives, may drive public bonds prices down and their interest up.
    Banks liquidity ratios have been thought for the purpose of alleviating systemic financial risks (merely dissuading banks to borrow short term money as a mean to finance long term assets) Should one be willing to dig further.please read the ECB monthly bulletin where M1,M2,M3 are available)
    This is an economy of distorted capital allocation that was states controlled, leaving the most genuine thoughts of money supply,interest rates as an oddity.

  8. E. Barandiaran

    James,
    Like or not, you and your readers will benefit a lot of knowing a little about the history of Argentina and why in your country inflation is not a problem right now but it may become a serious one.
    Let me first give you a brief on Argentina’s history:
    1. For all practical purposes, Argentina became an independent country in 1861 rather than 1810, so by 1930 its “constitutional democracy” was much younger than the US one. In the 70 years to 1930, Argentina became populated with Italians, Spaniards, and to a much lesser extent with people from other European countries. Also, the economy grew at high rates so just before the Great Depression it was expected that Argentina would soon enjoy one of the world’s highest income per capita.
    2. After September 1930, the weaknesses of Argentina’s constitutional democracy and the Great Depression changed everything. The foundations of both the political and the economic systems were questioned. Argentina was neutral in WW II, and by the end of the war Perón was elected President (he was ousted in 1955, and then he was President from October 1973 until his death in July 1974) and he was able to build a coalition that has dominated politics until today (as long as the coalition remains united it can easily win a presidential election). He was what we call in LA a populist, meaning that he not a socialist (like Allende in Chile). In the late 1940s he (with Evita) spend the huge reserves accumulated during the war. By 1951, however, he had run out of reserves and started to rely heavily on the inflation tax.
    3. Between 1951 and 1982, inflation was high (usually between 20 and 30% per year) but there was no hyperinflation. The first episode of hyperinflation happened in the second half of 1982 and it was the direct result of trying to solve a large financial crisis. Starting 1981, Argentina was the first country of LA’s lost decade to have both a private debt crisis and a fiscal crisis. The government first assumed responsibility for the private sector’s foreign debt but that precipitated a large foreign exchange crisis (and according to some observers the Malvinas/Falkland War of April/June 1982). At the end of the war, there was a serious economic crisis and two Ph.D. Harvard economists (Dagnino Pastore and Cavallo) triggered the first hyperinflation by prohibiting the payment of interest on bank deposits of less than 90 days (at that time 100% of the deposits were at 7 days or less) and paying with cash the run against the banks. Until March 1991, there were several episodes of hyperinflation as the succesive governments were not able to generate a fiscal surplus to service the debt and they continued to print currency to finance the large deficits.
    4. Since March 1991 until today (and tomorrow), succesive governments have had to be very creative to finance an increasing total expenditure. First, it was the sale of assets and surprisingly a new access to foreign credit. Then, it was the famous “corralito” (an attempt to steal bank deposits), the repudiation of the foreign debt, the re-introduction of multiple exchange rates to tax agricultural exports, the steal of private savings from the new pension system, and today the attempt to use creatively the international reserves. Indeed Argentina still has serious fiscal problems: it’s financing a large expenditure with funds that impose high costs on the economy and most government services are terrible. Since 2003, the economy has not been doing poorly because of the high prices of commodities.
    That long history of inflation supports your point about the relationship between fiscal deficits and “monetary” expansion, but I define money as currency not as the monetary base or an aggregate of currency + some bank deposits. In Argentina, both the central bank and the Treasury have had limited access to credit markets (only with IMF support they have been able to access them, but let me say that most of the time the IMF has been wrong about Argentina’s commitments). Access to these markets is critical to the financing of fiscal deficits and to the expectation that future deficits will not be financed by the inflation tax. As shown by Argentina’s experience when people start to doubt about the access to credit markets, the effects of relying on the inflation tax can be delayed by creative accounting of transactions so it is not clear first how big the deficit is and second how past deficits have been financed and the current one is being financed. In addition to theoretical arguments to define money as currency only, these accounting tricks make necessary to identify properly the terms of each financial asset purchased or issued by the central bank and the Treasury. In particular, you cannot aggregate currency and bank reserves with the central bank (this aggregate is the monetary base) because the terms of these reserves are often changed by the central bank. The history of Argentina’s inflation is one of guessing both the changing size of annual deficits and the changing sources of financing them. I hope you start training people on how to guess them. Thus, for the reasons you mention in your post, the US deficit may already be much higher than reported, but more important, you don’t know how it’s being financed. We know that if the large deficits last too long, at some point the government will rely on the inflation tax, but we cannot predict when this will happen.
    BTW: you may start the training using the accounts of your home state of California whose fiscal deficits will last for a long time, will change erraticaly and will be financed by all sorts of Argentinian tricks.

  9. Raphael

    Dear Prof. Hamilton: I don’t fully understand the argument about money and federal debt having the same consequence on inflation. Dr. Hussman is of the same opinion and presents a good summary this week (http://hussmanfunds.com/wmc/wmc100119.htm).
    What I learned in Econ 101 is that if there is an excess of government debt, the price of these securities fall, interest rates rise and put downward pressure on inflation, while if there is an excess of money, the value of money falls and inflation results. What is wrong with this logic?
    In my humble opinion, the government issuing bonds should not have any different effect on inflation (assuming of course the central bank doesn’t monetize it) than corporations issuing bonds: they both must be met with demand otherwise interest rates increase, but there shouldn’t be an effect on inflation. Well of course you could argue that corporations invest in more productive assets.
    And as an example, there is Japan, Germany, France, etc. which all ran up significant fiscal deficits in the past 20 years while maintaining price stability.

  10. Cedric Regula

    The part that makes me anxious about all this is we are still in a period where what we are doing sounds suicidal in the long term but, in the short to intermediate term, economist can still disagree upon the nature of the problem.
    Personally, I’ve become convinced that inflation and deflation are really nonsense terms. But that’s just because my living depends more on identifying nonsense rather than propagating it.
    Inflation because it is whatever the government says it is. There are some loose bounds of believability, but we get to exclude or grossly underweight asset prices, commodity prices, health care costs and taxes. And if you are in a well connected union (government or private sector) you can still get a raise instead of being laid off.
    Deflation because everyone chooses not to make a distinction between debt deflation and price deflation. We have debt deflation already, but we do not have price deflation, even using the CPI as the the measure.(Agreed that may change in 2010, with imputed rents as the tool of government statisticians. It CAN go down, if not up.)
    I very much agree with JDH that in a credit based and electronic based economy it is the monetary base that tells us how much base money-credit is available out there. Then the lately extremely variable velocity/money multiplier will ultimately have the end effect on the economy, depending on credit demand of course. That assumes that we still lend money expecting it to be paid back, rather than have the Fed toss it from helicopters. (or trains, Argentina style)
    Except that it is a world economy, which is a point domestic economists keep missing. Citi just hired a “trading manager” for Africa at a guaranteed three year compensation of $15 million. Your tax dollars at work. We may just continue on with stimulating EMs directly, instead of having the US consumer buy things from them.
    The caveat is that banks may still be capital constrained, but only micro-economists can tell us that. I think the answer is that there are “haves” and “have nots”. The haves are the likely suspects, and are the ones that do the least as far as traditional banking activities in the US economy. The have-nots are being kept solvent on paper thru Fed, Treasury and loosened regulatory support. This would pump up the “excess” reserve figure, but marginal banks know it’s not real and will act in self preservation.
    But rather than just call it quits and refer to macro-economics the barbarous relic of the sciences, maybe we should play along and try and compute what the future US trajectory is. We could define some outlier bounds. Take Japan as the lower “deflationary” bound and Argentina-Zimbabwe as the inflationary upper bound. Then we could come up with all the reasons that the US resembles and doesn’t resemble the “Outer Limits”.
    My vote is we steer policy more towards the Japanese bound, tho I don’t think 220% government debt to GDP is an achievable metric for the USG.

  11. Lord

    Why were they invited to the party? The weren’t. They threw it. How do we prevent a resurgence of inflation? We shouldn’t try. We need more inflation to act as a tax on mercantilism.

  12. RicardoZ

    How do you define bad inflation? There is no question that we are and will have inflation. The question is when is it too much.
    Is 25% over the past 10 years too much? It is only 2.5% per year. Prior to the Great Depression this would have been outrageous inflation. Today it is taken as matter of fact. People make buying decisions assuming inflation.
    JDH and Mankiw are right that we probably won’t see hyper-inflation in 2010, but the pressures of inflation are already being felt. I would say that in the next 10 years we will experience much greater inflation than we have the past 10 years and the reasons are stated by both JDH and Mankiw.

  13. Anonymous

    There is, I think, a big difference between what the public has in mind in discussing inflation and what is being described here. First, wages are on the other side of household budgets from consumption. Wages are not an element of inflation, from the non-economist’s perspective. They are an offset against inflation. Of course, everybody else’s wages are an element of inflation, but only in particular cases. Overall, wages are what needs to go up when prices go up. The fact that wages aren’t going up makes inflation a bigger problem, not a smaller one.
    I would also point out that in writing about wages as in terms of inflation, you are directing out attention to an input to inflation. It is an entirely different thing to the direct our attention to owner equivalent rent. The importance of that series is mostly an artifact of the construction of CPI. Yes, housing prices are part of the cost of living, but the large part they play in CPI, the point you made, is pretty arbitrary. Why is it important to inflation, actual inflation, that the CPI is constructed in a certain way?
    I make these two points because I’m not really sure where you are trying to take us here. You start by asking whether inflation fears are reasonable. Whose fears do you have in mind? the general public? Economists? Policy makers? The public isn’t impressed, when taxes and other deductions from paychecks are going up, that wages aren’t. Taxes and other deductions aren’t necessarily picked up in official inflation calculations, but most of the non-economists I know go directly to those deductions when making the point that the cost of living is rising. The fact that owners equivalent rent is weak and getting weaker is interesting to a forecaster – expect core CPI to get close to zero, year on year, sometime soon. But that doesn’t matter much to anybody not changing residence, and it pretty much doesn’t matter to monetary officials, who know the trick.
    What are you trying to say here?

  14. Tom

    Well argued. Mankiw is ridiculously wrong in stating that the Fed hasn’t been creating money to fund government spending. The Fed bought $300 billion worth of Treasuries, which absolutely, incontrovertibly funded government spending. That’s more than the ARRA cost in 2009. On top of that, the Fed’s purchases of MBSs replaced a previous Treasury program to purchase MBSs. So, instead of funding government spending, the Fed undertook the spending itself. What’s the difference? Only one, that the Fed spending is with newly created money and thus also adds to the pool of capital in the financial system, which allows the Treasury to borrow money at lower rates than it would otherwise have to pay. In that sense, the Fed purchases of MBSs also indirectly support other government spending.
    However I don’t think we should be only concerned with consumer price inflation and the official calculation of it. There are many kinds of inflation, some of which are already occurring, eg asset and commodity price inflation.
    And I disagree with you when you “see no conceptual distinction between short-term T-bills issued by the Treasury and interest-bearing reserves created by the Fed. Both represent liabilities from the government that must be repaid with interest.”
    The Fed is not obligated to repay anything, and not even to continue paying interest, the rate of which is set as the Fed believes is appropriate to regulate broad money supply. The tradition of referring to central bank money (reserves or currency) as a “liability” of the Fed is an accounting terminology used by the Fed which harks back to the days when dollars could be exchanged for metal. But in fact these days the Fed is not liable to holders of dollars for anything. The interest-bearing reserves being created by the Fed are dollars in the hands of their owner, who received them by selling something (MBSs), and who can spend, lend out, or save those dollars as they wish. It is true that the value of dollars depends very much on how many the Fed issues, just as the value of Treasuries depends on how many the government issues.

  15. JDH

    Anonymous at January 20, 2010 09:35 AM: I like to try to talk in terms of observables rather than idealized constructs or intangibles. By “inflation” I refer to what is measured by the PCE or CPI. I make the observation about wages because wages are an important factor that determines what the PCE or CPI number will be.

    Tom: The funds in question are either held as reserves or they are withdrawn as cash. Those are the only two possibilities. If withdrawn, the Fed must worry about the inflationary implications of that much cash in circulation. For this reason, the Fed is thinking in terms of raising the interest paid on reserves to whatever is required to persuade banks to continue to hold these funds as excess reserves. Persuading them to do so is in my mind exactly the same as rolling over the debt another night. True, once it becomes cash in circulation, it is a “liability” of the Fed in name only. But the Fed has a very real and substantial liability if it is determined not to let that cash get in circulation, and that liability is exactly the issue I am discussing here.

    The Fed is borrowing those funds in just the same sense and for exactly the same objective as when the Treasury was borrowing directly from the public on behalf of the Fed.

  16. bill northlich

    Wow, zillions more “Government is stupid” guys. Everywhere I look!
    Dr. Hamilton wants a “credible and responsible commitment from Congress that it is not going to allow the debt-to-GDP ratio to continue to balloon over the next decade”. What this means to most people these days is “stop the evil government from spending”. But, as Krugman and others have pointed out, we need a spender of last resort to generate econ. activity. The key is generation of economic activity. Invisible Hand types want the government to do nothing, ever. But without econ. activity firing back up, you get no taxes in, so you -can’t- be “responsible”. You just sit here for years.

  17. pat

    JDH,
    Very well said.
    You may find it’s interesting that US treasury appears to agree with you on the longer-term inflation outlook: they are planning to increase the average maturity of outstanding treasury debt from about 50 months currently to 72-84 months in the next few years, and they are reducing the supply of TIPS (as a share of total net supply of couponed treasuries) drastically: TIPS share of total net issueance of couponed treasuries was almost 40% in ’06, declined to ~30% in ’07, 10% in ’08, 2.5% in ’09, and likely under 2% for 2010.
    As for inflation, while I agree it will not be an issue near term partly for the roughly flat rent and oer components, I also want to point out that this will cause a disconnect between many people’s perception and statistics: most homeowners will not view a fall in their house prices as a fall in the 30% of their living expenses. I am not saying CPI is wrong, it is still better than most alternatives, just that inflation expectations may be higher than suggested by statistics due to this gap between perception and measurement.

  18. Rob

    RicardoZ:
    Each and every time I see price inflation, or cartons being cut in size but not price, I am outraged. Outraged that my savings are not a store of value. Outraged in that after tax, on almost-phantom earning on saving, I am not doing so well, possibly negative.
    Outraged in that savers are punished in this environment while debtors are, what exactly? (moral dimension aside, we, as a country, incent people to become debtors)
    Outraged that at 2.5% inflation, my prospective purchasing power, ceteris paribus, is cut in half in ca. a generation. I do think about inflation, I do not think highly of it. And if the majority of people in this country were savers…?
    Nor am I a retired person complaining here.

  19. Cedric Regula

    Rob,
    I am (very young one, pre ss and medicare), and let me tell you, its scary. Just take what savings you think you will have, invest it as well as you can (better than a .5% bank CD, lets hope, otherwise you will need 5 million bucks) then pay your taxes and use one of those handy econ deflators and see what you have left. Lots of luck everyone!
    But on the brighter side, just heard some good news on the job front from my buddy in California. He has a buddy who retired (early) from being a cop and recently decided he needed a job. He just got one at a high security mental institution! There is a law in CA saying that EACH inmate of these establishments must be guarded 24/7 by TWO qualified security people. My friend says it’s not really the case that the place is full of Anthony Hopkins types. Most are incapacitated to the point of being harmless. The one my friend’s buddy guards is in a walker, not a face mask, and couldn’t take a bite out of him if he tried. How much does it pay, you ask? $35/hour per security guard!!!!
    So the government does create jobs, and keep that little story in mind when the State of CA tries to hit up the Federal government soon for more aid money.

  20. don

    Agree with jdh. Mankiw is devilishly clever fellow, but he is too optimistic about the economy, as he was consistently before the recent debacle.
    In future, fed losses that must be made up by taxpayers may bode ill for its independence, and with good riddance. If I am right about the losses, a Congressionally run insitutuion could hardly have done worse.
    China also appears to agree with your assessment. It has divested itself of much of its long term U.S. debt (long term Treasury and GSE debt).

  21. GK

    Gold is not a very good hedge against inflation.
    The best hedge against inflation are technology stocks, specifically semi, storage, and software companies heavy in IP.
    Why?
    Because their costs are always dropping due to Moore’s Law and similar forces. This is independent of the inflation rate. Hence, more inflation reduces the value of each dollar, which allows tech companies to either expand margins, or boosh revenues (i.e. the $200 iPhone pricetag gets cheaper, the amount of computation power per dollar increases at a greater speed, etc.)
    The last time there was high inflation, the 1970s, the tech industry was insignificant.
    But this time…..
    I think people will be surprised by how well Tech Stocks do in a high-inflation environment, where upgrades are speeded up, and adoption is faster due to pricepoint devaluation that inflation causes.

  22. Johannes

    @GK : thanks for that promotion of my stocks.
    @JDH : “Greg Mankiw’s source of reassurance is thus the cause of my personal anxiety. I think the separation between monetary and fiscal policy has become increasingly blurred.” Congratulations James, you have hit the nail. Those interests have been followed, doing so ? Guess you will say : it had to be done, cause the financial crises and …

  23. Tom

    Jim: Okay, I understand how you’re looking at the Fed relationship to holders of reserves. But I disagree with it.
    It is not true that reserves can be either maintained as reserves or withdrawn as currency. They can also be spent or lent to another party, in which case they will most likely (in the current situation, in which reserves earn interest) continue to exist as reserves. But these reserves will get a new (if lent out, temporary) owner, and will possibly move to another bank’s reserve account.
    I don’t see how the Fed has borrowed this money. Who from? The seller of the MBSs? The bank that accepts and holds the reserves on behalf of the MBS seller?
    And when does repayment occur? When a reserves dollar is converted into a currency dollar? When a reserves dollar is destroyed (assuming most of the reserves that have been created in the last year will eventually be destroyed)?
    You’re right that the Fed needs to continue paying interest if it wants to discourage reserves from being converted to currency. But you imply that the reason that such conversion is inflationary is that currency is somehow more liquid than reserves, which is wrong. The reason why such conversion is inflationary is that the conversion of reserves to currency occurs through an increase in private bank lending, which in turn generates an increase in demand for currency, and that increase in private bank lending (and conequent increase in the supply of commercial bank money) is several times larger than the amount of demand for currency that it creates.
    But thank you for opening up a discussion on this topic, which is very little understood and is not being explained by the Fed, the government or mainstream media at all.

  24. JDH

    Tom: Certainly reserves move between banks many times each day as the funds are spent or lent. But the number we are talking about is the balance on somebody’s books at the end of the day. These funds, by definition, were neither spent nor lent but instead were held by the bank overnight.

    With each dollar of reserves, the Fed has made a promise to deliver one physical dollar on demand. How is that commitment different from a loan? Your original answer was, it’s different because the Fed can just print the dollars it’s promised to deliver, so the obligation is no big deal. But my response to that was that if the Fed is not willing to deliver those physical dollars– and I judge that the Fed indeed is not willing to do so– then it is a big deal, and this obligation of the Fed to deliver the dollars is precisely what is under discussion here.

    The Fed’s plan is, we will promise to pay you even more dollars tomorrow if you don’t ask for green bills from us just yet. That to me sounds an awful lot like an interest-bearing loan.

    You also haven’t addressed the last point in my previous comment. Do you agree that when the Fed asked the Treasury to issue new T-bills on behalf of the Fed, that this amounted to the Fed’s funding its programs with borrowed money? If so, in what sense is what the Fed is doing right now on its own any different?

  25. Michael Krause

    This inflation/deflation debate is the most important one facing money managers to this day, and certainly makes for a heavy dose of wonder. I think the story here is all about unintended consequences of policy action. The Fed’s ability to pay interest on reserves is a second tool of money multiplier control (the first being adjustment of required reserve ratio). What will the unforeseen effects of this policy into the future?
    While it may enable the Fed to more precisely control money supply, it doesn’t solve the problem of fiscal insolvency, real jobs lacking, etc. And as we’ve seen in how this crisis was handled, the tail is the real economy and government funding status, whereas the dog is the Fed. When the tail wags, the Fed complies. That makes it easy to fear cash, in the long run at least. As long as one stays employed.
    My gut feeling says we need an inflationary event (ie 100%+ price/wage move up) to get out of this mire, as the cause of the problem is debt and insolvency. Weaker currency has its obvious economic activity inducing benefits as well.
    It seems the political tides are turning hard in a deflationary pro-regulationary direction, ignorant of funding problems. I believe the high induced by a surging stock market and stabilizing credit spreads has compelled complacency in the political ranks. Example: All of these policy proposals (TARP reclamation tax, prop trading limits) to reclaim capital from banks, when many/most are still technically borderline insolvent and unwilling to lend. Recapitalization is still needed. Just two banks (JPM and GS) and a handful of exceptional regionals (ie PNC) posting quasi-monopoly profits are not enough. The inflation-deflation stalemate that exists right now is perhaps a testament to the Fed’s success in properly tuning monetary policy, as CPI remains relatively stable. Perhaps the plan all along has been the Fed gaining more control of the credit money part of money supply. In aggregate, it now better controls the whole money supply. The congress + executive branch on the other hand receives a big F, as evidenced by the jobs # charts (also, anyone notice weekly claims looks to have bottomed, 2 weeks of turning up?).
    In the end, if job #s still languish (and implicitly tax revenues fall), there is no way (in the long run) the Fed will back off from monetizing. I would be stunned if they sold their MBS portfolio into such an environment. The path of least resistance, even though it may take a while, is monetary inflation (and probably an impoverishing one where wages lag).
    There is good news: Looking on recovery.gov, out of $158B of actual spending programs rewarded, only $37B has been spent. The good news being that there is still $100B+ of real stimulus to happen. The bad news: These paltry numbers prove how impotent policymakers were in constructing and passing fiscal policy. It actually makes me proud the Fed exists to subvert them. Without a doubt, I’m in the Krugman camp that we need another $500B of no-lag job-creating measures (that number I made up, I’m sure his # is similar or higher). From there, we can hopefully get back on track to raising tax revenues based on higher economic activity, and not arbitrary money supply reducing bank taxes.

  26. RicardoZ

    bill northlich,
    I am officially applying to be the “spender of last resort.” Understand that I will do the job more quickly (within one day) and with greater efficiency than the government with virtually no overhead so the cost will be significantly less.
    Please let me know if you agree with my employment and I will send you my address so that you can mail me a check for $5,000. That should be a sufficient start. Next month you can send me more if the economy does not turn around.

  27. Cedric Regula

    Tom and JDH Fed “borrowing” discussion:
    JDH is merely taking the “snapshot in time” view, which is a core accounting principal, and the Fed does indeed appear to be “borrowing” from banks.
    But we also know that over the longer term the Fed did QE, and I even saw Ben admit on 60 Minutes that he bought those by creating dollar electrons at the Fed, which he then used to purchase $300B in longer term treasuries, $1.25T in long term MBS, and $200B in GSE corporate debt.
    So in non accounting terms, the Fed flooded the financial system with dollar electrons, and then borrowed them back. Cheaply at the moment.
    In past, happier times, the Fed did open market ops with short term T-Bills to adjust liquidity up or down a little bit. They stuck with short term paper because the value of it doesn’t change, and it has a near term auto destruct feature where the dollar electrons get returned to Fed shortly, then the Fed database administrator dutifully deletes them from the Fed hardisk and notifies the Fed accounting dept to make the appropriate adjustment to the Fed balance sheet. Then the Fed Board makes a new judgement about whether the system needs more or less dollar electrons.
    So the problem the Fed has now is the long term nature of it’s holdings, and liquidity, meaning selling price of it’s assets. They made the transition from managing money supply to managing insolvency of the banking system and also trying to bend the entire yield curve. This is no small task.
    But I still think they can learn something from the Chinese. The Chinese just raise reserve requirements(or capital requirements, which would accomplish the same thing and be more in line with modern Basel rules) when they want to rein in money supply. On the other hand, the reason the Fed doesn’t want to do that is it would probably make insolvent banks look insolvent. We can’t have that in the USofA.

  28. don

    “The Treasury should not assume it can always roll over an increasing volume of debt simply by issuing more debt,”
    Bon dit. Nor should the rest of us, but I’m afraid U.S. policy is based on this very premise. When the assumption becomes widely questionned, which would probably happen very suddenly, we may see a real crisis.

  29. Cedric Regula

    Here’s some evidence that all bankers may not be as dumb as we think. I did have some concerns about the Fed being able to react quickly enough to a resurgence in lending. But this is tempered by the fact that consumer debt is still very high, and banks may have still have trouble finding qualified borrowers.
    But Wells Fargo is saying they have been “keeping the powder dry” BECAUSE of Fed QE. They say they are also passing up on the dollar-treasury note and bond carry trade. Probably fearful of timing the exit plan I would think. That’s why I don’t do it. So that would be a counter productive result to ZIRP and QE. But at any rate, we have one more reason for the huge excess reserve number. They are waiting for the USG to give the economy back to the private sector on terms it can live with. Pimco made a similar move to low risk, more liquid positions lately too. But then, when rates go high enough, what if they are still able to fire all the cannon at once?
    ======================================
    Howard Atkins, Wells CFO: Well, that is a good question, Betsy, and the Fed obviously is active in buying MBS. And despite the fact that the yield curve is as positively sloped as it is right now, their active purchases is a factor that is, in some senses, artificially keeping long MBS yields lower than they might otherwise be. At some point presumably, they will either gradually or more quickly reverse course and that could lead to an increase in mortgage interest rates. And as I mentioned a couple of times in my remarks, in possible preparation for that, we have been keeping our powder dry, in effect underinvesting this large base of core deposits that we have for the possibility that that reverses course.
    http://www.calculatedriskblog.com/2010/01/wells-fargo-on-interest-rate-risk.html

  30. Tom

    Jim: It seems to me we’re disagreeing about how to think about the facts, more than we’re disagreeing about the facts. I disagree that the Fed is in fact borrowing funds, but I understand that there are some similarities and that for some purposes it might be insightful to analyze it from that angle.
    Just to make myself clear, I’ll go point by point.
    You asked: “Do you agree that when the Fed asked the Treasury to issue new T-bills on behalf of the Fed, that this amounted to the Fed’s funding its programs with borrowed money?”
    Yes, absolutely.
    You asked: “If so, in what sense is what the Fed is doing right now on its own any different?”
    In the above case, money was borrowed by Treasury, when it sold the T-bills, which was then essentially lent on to the Fed, when the receipts were deposited in an account at the Fed, to be, essentially, spent by the Fed (or in fact, left in an account at the Fed, which balanced out other expenditures made by the Fed so that the impact on money supply was neutral). In sum, third parties lent dollars to Treasury to fund Fed expenditures.
    There are no third parties lending dollars, neither to the Fed nor to Treasury, to fund the Fed’s current purchases of MBSs. The funding is coming from dollars that the Fed is literally creating out of thin air. Nobody is lending these dollars to the Fed. Nobody had these dollar before the Fed created them in the course of its purchase of MBSs.
    You asked: With each dollar of reserves, the Fed has made a promise to deliver one physical dollar on demand. How is that commitment different from a loan?
    It is different because the Fed has done much more than make a promise to deliver one physical dollar on demand. It has delivered immediately a dollar in electronic form, which is just as valuable and just as liquid (albeit somewhat differently liquid) as a physical dollar. The fact that the electronic dollar can be converted to a physical dollar is just one of the features of the electronic dollar. If we’re analyzing only the micro level, there is no reason to attach special importance to the exchange of reserves for currency.
    You wrote: Certainly reserves move between banks many times each day as the funds are spent or lent. But the number we are talking about is the balance on somebody’s books at the end of the day. These funds, by definition, were neither spent nor lent but instead were held by the bank overnight.
    No, I disagree with you here on what I think is a point of fact. The reserves tallied at the end of a day could have been spent or lent that day, which would have resulted either in the bank assigning them to a new owner and continuing to hold them on behalf of that new owner, or in the bank transferring them to another banks reserves account, and thus their continuing to exist as reserves. The spending and lending out of reserves does not in and of itself reduce the volume of reserves, it merely changes the reserves owners.
    You wrote: if the Fed is not willing to deliver those physical dollars– and I judge that the Fed indeed is not willing to do so– then it is a big deal, and this obligation of the Fed to deliver the dollars is precisely what is under discussion here. The Fed’s plan is, we will promise to pay you even more dollars tomorrow if you don’t ask for green bills from us just yet. That to me sounds an awful lot like an interest-bearing loan.
    I disagree with your portrayal of the current situation. There is no pent-up demand for green bills that is being held at bay by the Feds paying of interest on reserves. The demand for green bills is a function of the volume of economic activity, and particularly commercial bank lending, and all sorts of factors such as the popularity of cash versus payment cards.
    If you try to look at the relationship between reserves and currency on the micro level, it seems irrelevant. The exchange of one for the other seems immaterial. A reserves dollar is worth as much as a currency dollar. A reserves dollar can be spent or lent out at least as easily as a currency dollar.
    The importance of conversion of reserves to physical dollars can only really be understood from the macro level. Reserves are only exchanged into currency when there is growing demand in the economy for currency. That growth in demand is a result of economic growth and/or credit expansion. The Fed can, in various ways, stimulate credit expansion. Until 2008, its standard method of doing that was to create reserves dollars by buying Treasuries, and not to pay interest on those reserves, so that banks were motivated to expand credit until there was extra demand for currency equal to the volume of reserves that had been created. That credit expansion involves a money-multiplier effect, in which several new commercial bank dollars are created for every reserves dollar converted to currency. However, that method became over-stimulative when the Fed started making large-scale purchases of assets during the 2008 bail-outs and continuing with the 2009 Treasury purchases and ongoing purchases of MBSs and GSE debt. So the Fed began paying interest on reserves. This eliminates most of the motive in the financial system for reserves to be converted to currency.

  31. JDH

    Tom: Perhaps our core disagreement is that you maintain that the Fed does not and should not care whether reserves are withdrawn as currency, whereas my position is that the Fed does and should care about this very much.

    Let’s start with our point of agreement. You say you absolutely agree that when the Fed asked the Treasury to issue new T-bills on behalf of the Fed, this amounted to the Fed funding its programs with borrowed money. I presume we also agree on the mechanics of exactly how that worked. These were implemented in the form of two offsetting operations. The first step was that the Fed extended funds through, say, the Commercial Paper Lending Facility. The way it did so, in your language, was to create the funds for the CPLF out of thin air. If the Fed created these funds out of thin air (and it did), in what sense did it need to borrow money to fund the program, that is, why was any second step necessary? The answer is, the Fed did not want the reserves it created as a result of the CPLF to end up as currency held by the public. To ensure that objective, it asked the Treasury to borrow a substantial sum from the public and just leave that sum in the Treasury’s account with the Fed. The consequence of this second step was that the reserves the Fed created in step 1 ended up in the Treasury’s account with the Fed as a result of step 2. As long as the reserves through these dual operations ended up in the Treasury’s account, they weren’t going to end up as cash held by the public. Mission accomplished. The Fed needed to borrow not in order to conjure funds– of course it can always do that without borrowing. The Fed needed to borrow in order to prevent the conjured funds from ending up as cash held by the public. But we both agree, apparently, that the correct language to describe this process was the Fed funded its programs with borrowed money.

    Now as for the functioning of the market for reserves itself, the role of end-of-day reserve holdings is crucial. Reserves are neither created nor destroyed as banks pass them to each other. But there is a key decision a bank manager makes for 5:00 p.m. closing. The decision is, I can either keep these funds in my account with the Fed, or I can use them to make an overnight loan. The key condition for equilibrium is that the quantity of reserves that banks are planning to hold in their accounts overnight exactly equals the supply that the Fed has put out there. As a fund manager, I look at what alternative return I could get from anything else I might do with the funds other than just keep them at the Fed, and compare that with whatever benefits I perceive from keeping them at the Fed. The way this market functioned a few years ago, said benefits were derived from the cushion against uncertain last minute outflows that excess reserves provided, and demand equaled supply at a very low level of excess reserves. But in the new system, the Fed is competing with those alternative uses of overnight funds by directly paying interest, in order to support an equilibrium in which excess reserves have become a huge asset holding of banks. It’s just a matter of comparing the interest rate the other bank is offering me for use A of those overnight funds with the interest rate the Fed is offering me for use B of those overnight funds.

    If I lend reserves on the fed funds market, I’ll have them back tomorrow to do what I want with– the correct language to describe this is that I’ve lent them to the other bank overnight. If I keep them in my account with the Fed, I’ll have them back tomorrow to do what I want with. I’m saying you should call that lending to the Fed overnight.

    The proposed Term Deposit Facility functions just the same way, except that the Fed would acknowledge it is borrowing the funds from banks for longer than overnight. The proposed increased use of reverse repos by the Fed is also something that should be characterized as a loan from banks to the Fed. I describe all these as borrowing by the Fed, even though in all these cases, the funds that banks are loaning back to the Fed or the Treasury are of course the same funds that the Fed created out of thin air in the first place. In each case, the financial instruments we are talking about– whether it is the T-bills issued by the Treasury to fund the Fed’s supplemental Treasury account, funds lent to the Fed through the Term Deposit Facility, reverse repos with the Fed, or reserve balances that banks are persuaded to hold in their account with the Fed overnight– all have the same basic structure. The government (either in the form of the Treasury or the Fed) promises to deliver to the holder of that asset (namely to the owner of the T-bill, the lender for the Term Deposit Facility or the reverse repo, or the 5:00 p.m. holder of reserve deposits) the original borrowed sum plus interest. All such instruments are accurately described as borrowing from the public, and in the current instance they all have the same intended objective– to allow the Fed to engage in the various new programs without resulting in an increase in M1.

  32. Tom

    Jim: I think I now understand you and agree with you. Reserves are created out of thin air; they are dollars active in the economy every day, but lent back to the Fed every overnight.
    You still misunderstand me on one point: the Fed certainly cares about whether reserves are withdrawn as currency. My point is that to understand why the Fed cares, one must understand how the conversion process works. If it were a simple one-for-one exchange of reserves for currency, there would be no reason for the Fed to care. But the conversion happens through a chain of transactions which expands broad money supply by a volume several times greater than the amount of reserves converted to currency. What the Fed really cares about is that expansion in broad money supply, without which there would be no additional demand for currency and thus no conversion of reserves to currency.
    Regarding the 2008 Fed purchases financed by Treasury borrowing, everything you wrote is correct. Its worth reminding anyone else reading this discussion that it happened that way because the Fed had no authority to pay interest on reserves. Congress gave it authority late in 2008, specifically so that it could continue making large-scale purchases without relying on Treasury borrowing.

  33. Rob

    Cedric, Thanks for your insights regarding CA.
    Prof @10:13pm: Crystal clear analysis and summary, thank you.

  34. JDH

    Tom: Agreed. The reason I constantly refer to the reserves ending up as currency held by the public is because that’s the ultimate way in which the equality of supply and demand for reserve deposits gets restored. Without paying interest on reserves, and with more normally functioning financial markets, there’s no way you could imagine a sufficient increase in demand deposits such that banks wanted to hold a trillion dollars in reserves solely for transactions or reserve requirement purposes. As demand deposits and prices increase, demand for currency increases, and that is the process by which those reserves end up as currency held by the public. You are correct that it’s the entire process, not simply the final outcome of currency ending up in circulation, that is highly inflationary.

  35. Cedric Regula

    JDH and Tom money discussion:
    Shouldn’t we use the term “sterilization” to describe the Fed-Treasury process of 2008 (pre law change that allowed the Fed to pay interest on reserves). That would be more descriptive of the purpose of the Fed “borrowing” in that specific case, and also be an accepted concept in the world of Central Banking.
    Also, although I may be opening a can of worms here bringing things like money multiplier, velocity of money, high powered money, and maybe even the term “banking dollars” that Tom used into the discussion, but the one-for-one dollar sterilization move has got me curious.
    I generally get dizzy when I read about these things, then just decide to believe they are there. But if the treasury “borrowed from the public” to sterilize an equal amount of Fed reserve creation, for this to be non-inflationary, doesn’t that imply we have a money multiplier of “one” ???
    Or am I still mixed up about that?

  36. JDH

    Cedric Regula: “Sterilization” is a fine word to use in this context, and one I have used myself (e.g., [1],[2]) to help explain what is going on in terms of the consequences for M1. But here my objective was to emphasize the increasing commingling of monetary and fiscal policy, for which purpose I think it is helpful to call attention to the similarities between interest-bearing reserves and the conventional interest-bearing obligations of the Treasury.

    As for the “money multiplier”, the consequence of these steps is that the monetary base explodes but there is little or nor change in M1, that is, a money supply multiplier of zero. The objective of the policy is to achieve this very outcome.

  37. Cedric Regula

    JDH,
    OK, I got it. That’s even consistent with base money and M1 charts published in FRED, which is somehow comforting.
    I’ll take it one step further and propose the term “bank bailout” rather than “stimulative monetary policy” as another good descriptive term. So we also have a co-mingling of TARP and Fed monetary policy.
    But when we look under the macro hood, we still have “haves” and “have-nots” in banking. The Fed and TARP programs are plugging holes in the have-nots balance sheet, but the Wall Street haves still have access to all this liquidity and divert it to the “trading desk”. Here they punp up the asset du jour, stocks, bonds and commodities being the choice lately. These don’t get picked up in money aggregates.
    Of course that was probably an outcome that Ben was hoping for, even tho it didn’t seem to work with house assets. But at least the banks could sell some new stock at better prices and re-capitalize a bit.
    So we get $145B in bank bonuses, but at least no inflation. Yet. Let us be thankfull.
    And I still think Citi is going to send all the money to Africa.

  38. Spry

    Excellent discussion, Professor and Tom. I have one thing to add.
    Expansionary monetary policy in a recession typically means that the fed tries to get the banks to lend more to spur economic activity. Is the main point here that if banks start lending too much then inflation will start getting out of control?

  39. Cedric Regula

    Interesting post over at Kid Dynamite World about the “new” Volker banking proposed by Obama.
    Besides have a really cool name for a trader guy, he actually was one and knows what he’s talking about.
    But yes, I think it’s time to set the time machine for the 70s so the kids can learn to play the way they played back then. We’ll keep the ATMs though. And my discount broker. OK, we can have standalone hedge funds, mutual funds and private equity firms. If they’re public lets hope they remember they have shareholders. We still have to have the paper innovations pass the the toxic waste test too. Can’t have that contagion mucking up the rest of the world.
    Have fun, kids.
    http://fridayinvegas.blogspot.com/

  40. Tom

    On this MBS purchase question, I think it would interesting to fully trace the process, to really get a complete and accurate picture of what is going on.
    One point in particular puzzles me: If I understand correctly the MBSs are bought from the open market, and sellers do not necessarily have their own reserve accounts with the Fed. So generally the newly created dollars begin their existence in the reserves account of a bank which is holding them on behalf of somebody else. How, if at all, is that custodian relationship materially different from a demand account?

  41. Cedric Regula

    Tom,
    I’m not real sure but I think it works like this.
    1) I sold my small MBS bond fund position to Ben in an open market transaction. (They way I like to think about it)
    2) Ben transferred some fresh dollar electrons to my broker account.
    3) I transferred some but not all to my Internet checking account. My broker decided the best use of my idle dollar electrons was to transfer them back to the Fed. My Internet bank decided the same thing with my new deposit.
    4) Knowing the velocity of money dropped in half, a few days later I very slowly drove to Wal-Mart and carefully bought groceries and beer. I paid for them with a debit card, and got some cash back to cover next weeks gasoline and greens fees.
    5)My Internet bank immediately transferred the sum to Wal-Mart. My bank had the 8% reserve requirement for demand deposits on hand of course(no bank run was caused!) and less dollar electrons remained in my account. At the end of the day my bank totals up all the dollar electrons at the bank to make sure the 8% is still there. If not it borrows them from another bank or the Fed discount window until it can get more deposits tomorrow or sell some Tier I or 2 assets.
    6) Wal-Mart now has some fairly fresh dollar electrons and we have begun the money multiplier process. The theoretical upper limit on money multiplier is 1 divided by the reserve requirement on demand deposits. 1/.08 = 12.5 ! So my $100 grocery bill could somehow become as much as $1250 eventually thru the magic of the money multiplier.
    But I have no idea what Wal-Mart did next.

  42. Brian Macker

    Isn’t wanting “near-term stimulus and longer-term fiscal responsibility” one of the first signs of schizophrenia.

  43. Brian Macker

    I see nothing in the article that indicates that you haven’t had a break from reality on this issue. The government providing stimulus is an all around bad idea, and especially during a downturn.
    Look at this sentence from this article, “I maintain that the keys to preventing a resurgence of inflation in the U.S. are … (2) a return of the Federal Reserve to a primary focus on controlling the money supply rather than trying to target particular yield spreads.”
    Do you really think the Fed was “controlling the money supply” in the past? How can they return to a policy that they have never followed? They have in fact aggravated the expansion in the money supply ever since their inception.
    The Fed was founded on a belief in monetary central planning. However this cannot work for the same reasons that it doesn’t work in other areas. Central planning discoordinates market participates by destroying the very price signals that allow them to cooperate. It separates consequence from action. It destroys private incentives. It creates a moral hazard.
    The current stimulus is merely a repeat of the same policies we followed to get us into this mess, only on a grander scale. The “stimulus” is merely the Greenspan put writ large. The low interest rates also follow the same Greenspan put philosophy.
    The stimulus IS fiscal irresponsibility, as have been the policies we’ve been following since before Clinton was in office. Why isn’t wanting near-term fiscal irresponsibility in conflict with expecting longer term responsibility?
    I do agree with some of your points. Paying interest on bank excess reserves is equivalent to borrowing the money. There are differences from treasuries though. Treasuries have fixed terms, whereas banks can withdraw their excess reserves at will.
    Paying interest on non-excess reserves is just subsidy to the bank.
    Of course, the Fed already has the power to prevent any withdrawal of excess reserves without paying a dime. All they have to do is increase the required reserve percentage.
    Sooner or later the federal government will have to choose inflation. If they do not inflate then government debt in real terms will balloon, while tax revenues will decline. You know they will never take the other option, reduction in spending. Make no mistake, the Fed will do what the government needs.
    Yes, fractional reserve monetary deflation is in the cards for a while, but hand in hand so will be base money supply inflation. The worse the monetary deflation pressures are the higher will the base money supply inflation needed to counteract it.
    The very short term fractional reserve deflationary forces that deflationists are focusing on, are in fact the impedis for the future fiat inflation. Most don’t even distinguish the two type of monetary deflation/inflation, let alone distinguish between the many forms and categories of price inflation/deflation.

  44. Brian Macker

    BTW, I don’t think your inflation chart is valid for scientific purposes. The government changed it’s methods for calculating inflation, so if you are using their numbers you need to adjust at the points where the methods were changed. You either need to adjust past inflation down or current up to have an apples to apples comparison.

  45. Cedric Regula

    Here’s a good synopsis of what Volker banking may mean from the Zero Hedge blog(beware of anti-establishment views on this site, if that bothers you).
    This would go a long way towards reining in Borg Banking (I have to give Krugman credit for the invention of that term. But I like it, so I’ll use it)
    But I much prefer elimination of current Fahrenheit 451 policies rather than move to Bladerunner 66 (or 69) in 2020 after the financial system has drained all government resources and old people find out that the money they have paid into “entitlement” programs is not really there. Who knows, it could even happen to state and federal pensions too ?!?!
    http://www.zerohedge.com/article/volcker-revolution-providing-some-much-needed-answers

  46. Brian Macker

    That was supposed to be:
    “Central planning discoordinates market participants plans by destroying the very price signals that allow them to cooperate.”

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