Monday, March 16, 2009

Will there be hyperinflation in the US?

Often in discussions of the policy actions undertaken by the Fed in response to the financial crisis a concern is raised that the massive injections of liquidity will create inflation and even hyperinflation in the near future. This concern is based on the assumption that the money created by the Fed will translate at some point into purchasing power that will put pressure on prices to go up. Indeed from September 10, 2008 to December 31, 2008 the monetary base in the US – i.e. a narrow measure of money supply controlled by the Fed – has doubled from about $840 billion to over $1.68 trillion. In normal circumstances, this increase in the base will create too much liquidity in the system, which will increase lending, spending, and inflation. In the current environment, however, this is not happening. The money created by the Fed is stored in banks’ vaults (or technically, kept as deposits in the Fed). As a result, there is almost no increase in broader measures of money.

The graph below illustrates this quite vividly: Banks are required to keep a certain amount of deposits as cash in their vaults or as deposits in the central bank. It is in their interest to keep as little cash as possible because by not lending the money they lose the opportunity to earn interest. In normal times the US banking sector keeps about $2 billion in excess reserves (the dark blue area is hard to see before September 15, 2008) – i.e. cash above and beyond of what is required by regulators. In the post-Lehman six months the excess reserves have ballooned from $2 billion to over $600! In mid-March, the commercial banking sector in the US was required by law to keep about $57 billion dollars in reserves (light blue area), but the actual reserves are $670 billion.

In fact this graph shows why liquidity creation does not create inflationary pressure, but it also shows the biggest problem in dealing with the crisis: the lack of lending. We have seen this kind of piling up of reserves in a couple of other episodes – the Great Depression and the long slowdown in Japan in the 1990s and early 2000s.

What if banks start lending? Won’t this create inflation? If the Fed realizes that the money that they have injected in the economy creates inflationary pressures (i.e. lending resumes), then they can slowly or quickly (it is their choice) mop up the excess liquidity. They can do this in several ways – by closing down some of the newly created lending facilities or by a straightforward and simple increase in interest rates (and open-market operations). Will it work? It did in Japan. The next chart shows the near-doubling of the monetary base during the quantitative easing from 2002 to 2006. As the quantitative easing came to an end because the economy started growing and lending resumed, the central bank promptly withdrew the excess money and thus avoided the rise of inflation.
Ben Bernanke has made it clear several times that the increase in liquidity is only temporary and it can be promptly reversed to avoid inflation. If economic growth resumes and banks start pushing this liquidity to consumers and firms, there is little doubt that the Fed will react promptly to reduce the risk of inflation.

Ilian Mihov