Inflation, Credit Allocation, and the Fed

Inflation, Credit Allocation, and the Fed by James L. Caton  for AIER

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.

Monetarist Policy

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.

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