Ever since Ben Bernanke began his
massive infusions of money into the financial system, many analysts (including me)
have been worried about the severe weakening of the dollar if and when the
fractional-reserve-banking system magnified the initial injections severalfold.
Although the trend could reverse,
data from the past two months suggest that the inflationary big one may be
Keeping the Genie in the Bottle
To understand the potential
problem, we need to review some basic facts. Back in the fall of 2008, when
Lehman collapsed and the entire financial system appeared in jeopardy, the
Fed began bailing out investment banks through massive asset purchases and extraordinary
lending operations. These activities rescued the major banks that
would otherwise have gone bankrupt, by taking bad assets off their books (at
inflated prices) and by propping up the new "market" price of the
assets remaining on their books.
When the Fed buys an asset, it
writes a check on itself. This action creates new electronic reserves in the
banking system. For example, if the Fed buys $10 million in mortgage-backed
securities from Joe Smith, then Smith will deposit the check in his own
checking account. His bank will credit Joe Smith's checking balance by $10
million, but at the same time the bank's account with the Fed itself
will rise by $10 million too.
At any time, regulations insist
that commercial banks in the United States keep a minimum amount of reserves
set aside in order to "back up" the demand deposits (think of
checking accounts) of their customers. For example, if a commercial bank's
customers think they have a total of $1 billion in their checking accounts,
then the Fed's regulations force the commercial bank to keep (roughly) $100
million set aside in reserves. These reserves can consist of green pieces of
paper stored in the commercial bank's vaults, or the reserves can be
electronic entries showing how much the bank itself has on deposit with the
The following chart shows how much
in new reserves the Bernanke Fed has pumped into the system in the last three
Notice that "excess
reserves" are historically very close to zero. This reflects the
tendency (assumed in textbook discussions of "open market
operations") for commercial banks to quickly lend out any reserves they
have, over and above their legally required minimum. Yet as the chart above clearly
indicates, since the onset of the present crisis the commercial banks have not
been making new loans. Instead, they have allowed the huge injections of new
reserves to sit parked at the Fed.
There are several (possibly overlapping)
explanations for this break from the past. Keynesians such as Paul Krugman argue that this was the predictable
outcome during a liquidity trap. Proponents of MMT
(modern monetary theory) argue that the economic textbook discussions have
things upside down, and that banks are never constrained by reserves when
deciding on making new loans. Quasi monetarists lament
the Federal Reserve's decision in October 2008 to start paying
interest on excess reserves — a policy whereby the Fed
actually bribes banks not to make loans to their customers.
Free-market guys like Mish
(as well as some
card-carrying Austrians) have argued all along that significant
price inflation was never on the table, so long as the financial system
worked through a painful process of deleveraging.
Regardless of their specific
explanations for why commercial banks hadn't been lending out the
trillion-plus in new reserves Bernanke created, just about every pundit
agreed that this fact was a major reason that what seemed to be incredibly
inflationary policies weren't leading to skyrocketing prices.
However, if the trend of the last
months continues, that period of containment appears to be over. All of those
pundits who hedged their predictions by saying, "So
long as those reserves stay bottled up at the Fed …" may need to
go back to the drawing board. Recent releases from the Fed show that the
excess reserves are starting to leak out.
The Fed's Latest Figures on Reserves
Here are the relevant figures from
the Fed's latest
(August 18) H.3 release:
Reserves of Depository Institutions (millions $)
The above data are consistent with
the commercial banks finally beginning to lend out their excess reserves
— something that they typically do, but (for various possible reasons)
have not done during the current crisis.
To double-check our conclusions, we
can show that demand deposits at commercial banks have grown sharply over the
past few months, matching the aggressive growth exhibited back during the
panicky days of late 2008:
Moving From Money to Price Changes: Some
Before the reader runs to the gun
store (or jumps out the window) because of impending price hikes, I should go
over some caveats. First, we must always consider the supply and demand
for money. Clearly in late 2008, but also in recent months, the general
economic outlook was very bleak and this led households and firms to increase
their desired holdings of money (as opposed to other liquid assets). Rather
than viewing the banking system as pushing new money into the economy, some
economists would look at the above chart and see people pulling new
money into existence (through the magic of fractional-reserve lending).
A second nuance is to contrast
relative with absolute price changes. During late 2008, the official consumer
price index (CPI) was falling fairly rapidly. Therefore, even though it may
have been true that Bernanke's money creation led to "rising
prices," this tendency may have been masked by the underlying fall. The
net result was only a modest increase in CPI during 2009, which led many
critics of Bernanke to look like Chicken Littles.
The following chart shows what happened to CPI over the last ten years:
Note that in the above chart, we
are not currently staving off a plunge in consumer prices, but in fact are
following on the heels of a rather sharp surge in the official CPI.
A third caveat in our analysis is
that (as good Austrians) we must remember that there are millions of
different prices in the economy. The specific impact of money creation on
various sectors can be very different, and operate on different time frames.
For example, during the present
crisis, we had the Fed create more than a trillion dollars on behalf of rich
investment bankers. At the same time, middle- and lower-class
households were plagued by high unemployment, large debts, and underwater
homes. In this environment, it's not surprising that the various rounds of
"quantitative easing" went hand in hand with huge jumps in stock
and commodity prices, but were muted in the retail sector.
Drawing on the Bureau of Labor
Statistics' latest releases of the consumer and producer price indices,
we see that once we leave the specific metric — "core
inflation" — favored by Krugman and
other prominent economists, we get a very different picture indeed of the
trend in prices over the past year:
Price Change from July 2010 — July 2011
Price Index — crude goods
Price Index — intermediate goods
Price Index — finished goods
Price Index — all items
Price Index — ex food and energy
Austrian economists know to be wary
of looking at financial data and drawing conclusions about what
"must" happen. The future is always uncertain, the result of
volitional human action.
It's also true that we have reason
to be very cynical about the "official" data put out by the Federal
Reserve and the Bureau of Labor Statistics.
Even so, my point is that the
government's own numbers indicate that Bernanke's grace period may be ending.
These trends might turn out to be a blip — only further observation
will show — but we soon may see the Fed's "exit
strategies" put to the test.