Thursday, April 24, 2014
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Why Is US Inflation So Low?

CAMBRIDGE – Why has quantitative easing coexisted with price stability in the United States? Or, as I often hear, “Why has the Federal Reserve’s printing of so much money not caused higher inflation?”

Inflation has certainly been very low. During the past five years, the consumer price index has increased at an annual rate of just 1.5%. The Fed’s preferred measure of inflation – the price index for personal consumption expenditures, excluding food and energy – also rose at a rate of just 1.5%.

By contrast, the Fed’s purchases of long-term bonds during this period has been unprecedentedly large. The Fed bought more than $2 trillion of Treasury bonds and mortgage-backed securities, nearly ten times the annual rate of bond purchases during the previous decade. In the last year alone, the stock of bonds on the Fed’s balance sheet has risen more than 20%.

The historical record shows that rapid monetary growth does fuel high inflation. That was very clear during Germany’s hyperinflation in the 1920’s and Latin America’s in the 1980’s. But even more moderate shifts in America’s monetary growth rate have translated into corresponding shifts in the rate of inflation. In the 1970’s, US money supply grew at an average annual rate of 9.6%, the highest rate in the previous half-century; inflation averaged 7.4%, also a half-century high. In the 1990’s, annual monetary growth averaged only 3.9%, and the average inflation rate was just 2.9%.

That is why the absence of any inflationary response to the Fed’s massive bond purchases in the past five years seems so puzzling. But the puzzle disappears when we recognize that quantitative easing is not the same thing as “printing money” or, more accurately, increasing the stock of money.

The stock of money that relates most closely to inflation consists primarily of the deposits that businesses and households have at commercial banks. Traditionally, greater amounts of Fed bond buying have led to faster growth of this money stock. But a fundamental change in the Fed’s rules in 2008 broke the link between its bond buying and the subsequent size of the money stock. As a result, the Fed has bought a massive amount of bonds without causing the stock of money – and thus the rate of inflation – to rise.

The link between bond purchases and the money stock depends on the role of commercial banks’ “excess reserves.” When the Fed buys Treasury bonds or other assets like mortgage-backed securities, it creates “reserves” for the commercial banks, which the banks deposit at the Fed itself.

Commercial banks are required to hold reserves equal to a share of their checkable deposits. Since reserves in excess of the required amount did not earn any interest from the Fed before 2008, commercial banks had an incentive to lend to households and businesses until the resulting growth of deposits used up all of those excess reserves. Those increased deposits at commercial banks were, by definition, an increase in the relevant stock of money.

An increase in bank loans allows households and businesses to increase their spending. That extra spending means a higher level of nominal GDP (output at market prices). Some of the increase in nominal GDP takes the form of higher real (inflation-adjusted) GDP, while the rest shows up as inflation. That is how Fed bond purchases have historically increased the stock of money – and the rate of inflation.

The link between Fed bond purchases and the subsequent growth of the money stock changed after 2008, because the Fed began to pay interest on excess reserves. The interest rate on these totally safe and liquid deposits induced the banks to maintain excess reserves at the Fed instead of lending and creating deposits to absorb the increased reserves, as they would have done before 2008.

As a result, the volume of excess reserves held at the Fed increased dramatically from less than $2 billion in 2008 to $1.8 trillion now. But the new Fed policy of paying interest on excess reserves meant that this increased availability of excess reserves did not lead after 2008 to much faster deposit growth and a much larger stock of money.

The size of the broad money stock (known as M2) grew at an average rate of just 6.2% a year from the end of 2008 to the end of 2012. While nominal GDP generally rises over long periods of time at the same rate as the money stock, with interest rates very low and declining, households and institutions were willing to hold more money relative to total nominal GDP after 2008. So, while M2 grew by more than 6%, nominal GDP grew by just 3.5% and the GDP price index rose by only 1.7%.

So it is not surprising that inflation has remained so moderate – indeed, lower than in any decade since the end of World War II. And it is also not surprising that quantitative easing has done so little to increase nominal spending and real economic activity.

The absence of significant inflation in the past few years does not mean that it won’t rise in the future. When businesses and households eventually increase their demand for loans, commercial banks that have adequate capital can meet that demand with new lending without running into the limits that might otherwise result from inadequate reserves. The resulting growth of spending by businesses and households might be welcome at first, but it could soon become a source of unwanted inflation.

The Fed could, in principle, limit inflationary lending by raising the interest rate on excess reserves or by using open-market operations to increase the short-term federal funds interest rate. But the Fed may hesitate to act, or may act with insufficient force, owing to its dual mandate to focus on employment as well as price stability.

That outcome is more likely if high rates of long-term unemployment and underemployment persist even as the inflation rate rises. And that is why investors are right to worry that inflation could return, even if the Fed’s massive bond purchases in recent years have not brought it about.

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  1. CommentedParrain Boursorama

    Inflation does not come from too much money. It comes from too much money chasing too few goods and services. No chasing, no inflation.
    Read more at http://www.project-syndicate.org/commentary/the-inflationary-risk-of-us-commercial-bank-reserves-by-martin-feldstein#ssIGl5GEUBrdm4mW.99

  2. CommentedJared Hansen

    The biggest error in Feldstein's analysis can be seen here. He's got tunnel-vision on the money-supply-cause of inflation, but isn't paying attention to *why* money supply increases can lead to inflation. They only lead to inflation if they trigger a net increase in prices, and they only do that if suppliers feel there's a net-positive-outcome to raising their prices. But price increases hurt sales and benefit your competitors. Suppliers won't raise prices unless there are compelling reasons to do so. And if suppliers are operating with excess capacity unused (or inventories), their costs will often go *down* (due to a return to better quantity of scale) if they see a few extra orders. When there is widespread excess capacity in the economy, the only businesses that won't see this benefit are those that are selling goods at a loss!

    This doesn't mean that prices will go *down* when the real money supply increases - but it *does* mean they won't go *up* very easily.

    What all of this means is just the old-school Keynesian explanation still applies: if an economy is in a depressed state - ie, has significant underutilized capacity - increases in the money supply tend to not be inflationary. And it really has nothing to do with whether the FED is offering a tiny bit of interest on excess reserves or not.

  3. CommentedBarry DeCicco

    Noah Smith has a counter-argument:

    http://noahpinionblog.blogspot.com/2013/07/is-interest-rate-on-reserves-holding.html
    (Recommended by Paul 'Correcto' Krugman)

  4. CommentedRalph Musgrave

    A large number of people, me included, realised QE would have little effect when it was first mooted. But it’s good to see the charlatans at the Harvard department of economics finally seeing the light, even if their reasoning is nonsense. (See link below). Perhaps two other charlatans at Harvard, Rogoff and Reinhart will eventually understand why QE has little effect.
    http://noahpinionblog.blogspot.co.uk/2013/07/is-interest-rate-on-reserves-holding.html

  5. CommentedKenneth Duda

    This is craziness. How could a 0.25% shift in interest rates keep $2 trillion from being lent? You'd have to believe that there are tons of lending opportunities that are just barely too risky and/or not quite profitable enough, and if this paltry 0.25% interest on excess reserves just went away, boom, all of that money would suddenly be unleashed. It defies common sense. Noah Smith and Paul Krugman have good take-downs, e.g., http://noahpinionblog.blogspot.com/2013/07/is-interest-rate-on-reserves-holding.html.

    Yes, a $2T expansion in the Fed balance sheet has not caused inflation. But it is not puzzling. It is simply because here in 2013, we are demand constrained. With inadequate demand in the economy, it does not matter how much money you inject into the money markets. If no one wishes to borrow, new money results in no increase in economic activity, no increase in demand, no way for suppliers to raise prices, no inflation.

    Inflation does not come from too much money. It comes from too much money chasing too few goods and services. No chasing, no inflation.

    This is completely obvious to me, as a non-economist. Why on earth can't a Harvard Econ professor grasp this?

    So frustrating. If ever there were a time for economists to speak with one voice to help force policy makers to do the right thing to lift us out of this depression, it's now. Dr Feldstein and the like (John Taylor, John Cocrane, etc) are letting us down. You are partly responsible for millions needlessly unemployed.

  6. CommentedChristopher Lemieux

    I have come across a few aspects that say low inflation is due to a lack of global demand. Emerging markets are in the dumps, China is teetering off, and the developed world has been stagnating for nearly five years.

  7. CommentedHeriberto Arribas

    First a semantics question, too much money and few goods inflation, too much money and few shares? I think that is inflation too, and she isn´t so low. The question is more interesting: why only a side of the economy have inflation?

    In the 1970’s begin fight against inflation. The new Fed’s rules in 2008 may have helped or not. If in 2007 it had been inflation and she stop in 2008, ok, but for 20 years inflation was not a problem. The change can happen in this 20 years.

    In my view what is really interesting is not only low inflation in the real economy if also inflation occurs only in the stock, bonds, etc., not in both. Let me explain my view graphically. Suppose the economy until the 1980's as a lake. In the 1970's had too much water, money, ie inflation. The official version is that central banks battled inflation in the 1980's and won. But I think I just got lucky, won because there was a crack in the walls of lake and water has started out. Some water was returning to the lake, credits. But in 2007 the credits stopped, too much water out of the lake, danger of deflation. Now central banks instead of bailing him attempting to flood the lake but the water leaks through the crack. The outside of the lake is the financial market and the crack is its deregulation in the 1980's.

  8. CommentedJeremy Sparks

    Can't we just call this what it is: the same criminal group taking money out of circulation and giving it to their crony buddies! This time it's too their foreign banks and individuals mostly (which the article doesn't mention) which wouldn't exactly create massive inflation either. It's the same old story- money always gets taken out of circulation (less in all of our pockets) before EVERY depression or recession! This aint' a new concept- regardless of what you think of the bible, the story of Joseph outlines this scheme really well- "he took the peoples' money and put it in the Pharoe's house" and "in the third year the people sold themselves into slavery asking why hath our money faileth" This is why the most important aspect of economics is: WHO CONTROLS THE QUANTITY OF MONEY!! All the fancy words, bankers, instruments and programs mean nothing if you have foreign (not representative of the people) interests gaining wealth and monetary control on the upside and downside of every financial bubble they create. We think of bubbles in terms of industries or markets while central bankers think of bubbles in terms of whole nations and regions!

  9. CommentedErnest Jack

    Martin, this has got to be the most shallow analysis you've put forth recently. So we are to understand that because the FED determined to pay a paltry 25 bps we are now mired in low inflationary environment? Yes folks a full 0.25% annual return on reserves (notice how Martin failed to mention the rate cause its so meaningless to his argument). This is at best pure conjecture and it fails the compelling argument test. The banks are awashed in reserves because of private sector deleveraging that continues till today.

    Until the economy offers prospects of good returns based on the merits of organic economic forces and not QE and ZIRP induced asset price reflation, expect it to continue.

    1. CommentedChristopher Lemieux

      I have come across a few aspects that say low inflation is due to a lack of global demand. Emerging markets are in the dumps, China is teetering off, and the developed world has been stagnating for nearly five years.

    2. CommentedAdam Harper

      I think both explanations go hand-in-hand. The private sector would always like to borrow at depresed rates, the banks arent willing to take on the risk however. Toss in a riskless quarter of a percent and the problem exacerbates.

  10. CommentedScott Swift

    Um...I don't know where Martin Feldstein has been shopping (at the 1% Store?!?) or what bogus government statistic he is relying upon when he claims inflation is low, because prices are higher just about everywhere I shop and for just about everything I shop for. This Joe Six-Pack level of inflation is particularly acute when one takes into account smaller package sizes, lower levels of services, increasing numbers of service charges, baggage fees and the like. And I don't even want to talk about healthcare. Even housing prices are back up to close to pre-2008 levels, and residential rents are higher. The only rent categories that remain depressed are office and warehouse space. Time for a reality check, Dr. Harvard.

  11. CommentedProcyon Mukherjee

    The New York Fed paper makes a good observation: The Federal Reserve’s new liquidity facilities have created, as a byproduct, a large quantity of reserves and these reserves can only be held by banks. It would be wrong to construe that all the excess liquidity got parked as excess reserves and did precious little to lending. The total size of the reserves would not change with what the individual banks do but it would depend entirely on the Central banks liquidity initiatives.

    However the point the paper has missed to elaborate on is when normal conditions are about to return, the inter-bank lending should work as it was doing in the past, why then should we have the liquidity initiatives continuing at the same frenetic pace as before?

    Secondly if the interest on reserves is continued as a policy initiative it would continue to stall the money-multiplier, which comes as a direct conflict to the monetary policy objective itself, isn’t it? These two aspects have been not fully covered in the paper.

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  13. CommentedAlexander Shadow

    Why Are Banks Holding So Many Excess Reserves?
    Explains here:
    http://www.newyorkfed.org/research/staff_reports/sr380.pdf

    1. CommentedProcyon Mukherjee

      The New York Fed paper makes a good observation: The Federal Reserve’s new liquidity facilities have created, as a byproduct, a large quantity of reserves and these reserves can only be held by banks. It would be wrong to construe that all the excess liquidity got parked as excess reserves and did precious little to lending. The total size of the reserves would not change with what the individual banks do but it would depend entirely on the Central banks liquidity initiatives.

      However the point the paper has missed to elaborate on is when normal conditions are about to return, the inter-bank lending should work as it was doing in the past, why then should we have the liquidity initiatives continuing at the same frenetic pace as before?

      Secondly if the interest on reserves is continued as a policy initiative it would continue to stall the money-multiplier, which comes as a direct conflict to the monetary policy objective itself, isn’t it? These two aspects have been not fully covered in the paper.

    2. CommentedTomas Kurian

      This explains well why there are no inflationary pressures for as long as CB pays interests on reserves. But this interest paid by CB to sterilize excess reserves ( to prevent multiplier effects) also creates reserves, which need to be sterilized as well. What we have here is a compound interest mounting as a liability of CB with potentialy unlimited growth.

      How long will be CB paying ever growing compounding interest to sterilize excess reserves ?
      This induces moral hazard as retail banks see no incentives to lend as they will get their profits risk free.
      ( indeed, the less they lend the less risky profits they will get)

      I would see much better solution in introducing negative retail interest rates, as described in my work:
      www.genomofcapitalism.com, chapter 16.
      (of course, certain upgrade to our financial system is needed to make it possible, mainly to go fully digital to avoid possible bank runs).

      With this "soft" management of excess reserves CB is doing at the moment, we will get into the "FIN" problem, described in chapter 16.4

      Negative retail interest rates represent "hard" approach, which limits the amount of money in the system, thus curbing inflationary pressures and also promotes risk taking.
      And it is sustainable. Interest on reserves is not.

  14. CommentedAurelian Dochia

    So, in a way you say that the inflation did not increase because the money injected by the central bank in the economy through bonds purchases came back in the same coffers as excess reserves placed by the banks at the FED. It means the QE was largely ineffective because the central bank was sterilizing its own policy by offering to pay interest on excess deposits. Why would they do such a contradictory move?

    1. CommentedAhmet Ihsan Kaya

      I think Fed's primarily concern is bring back to confidence which deteriorated once in 2008. Once banks believe that households and businesses (the real economy) is strong enough to pay back their loans, they'll decrease their excess reserves and lend those who needs loan.

  15. CommentedFrank O'Callaghan

    Question: “Why has the Federal Reserve’s printing of so much money not caused higher inflation?”

    Answer: POVERTY.

    The US has created huge poverty in what was once the world's most prosperous society. The wealthy have so much that they have few -if any- unmet needs or desires. Human needs are not infinitely elastic. Human greed may not be equally limited.

    The other part of the society, the non-rich, have a lot of unmet needs but do not have the means to fill them.

    The solution is clear, obvious, simple, tried and true: Wealth must be transferred from where it is of marginal benefit to where it is of great benefit. Inequality is a blight on the economy and -more importantly- on the society and the civilization.

  16. CommentedStephen Griffin

    So in that case, the decision to start paying interest on Fed deposits has had ongoing contractionary effects? At least unless the spread comm banks are charging on loans is, in their eyes, a sufficient risk & liquidity spread.

  17. CommentedAlex R. Mumm

    I understand that the excess reserves are parked with the Fed and not being lent out, but why is it that we attribute the rally in the stock market to QE?

  18. Portrait of Eduardo Moron

    CommentedEduardo Moron

    What is clear then is that QE3 has only been effective in increasing bank profits. This was clearly not the stated objective of the program but to spur credit growth. If banks are choosing to keep the money as excess reserves it seems that the logical step is to start reducing the interest on those excess reserves. A little bit of inflation will do the trick of reducing real rates and therefore increase investment and consumption.

  19. CommentedJose araujo

    What I mean is that if Aggregated demand shift, Supply will follow, because we are far from the potential product, and further away even from out technology limits level.

    We have proof of that, by the way.

  20. CommentedJose araujo

    What I mean is that if Aggregated demand shift, Supply will follow, because we are far from the potential product, and further away even from out technology limits level.

    We have proof of that, by the way.

  21. CommentedJose araujo

    When banks start to loan the excess of reserves, demand of good will rise, and since we are far from full employment demand will follow.

    Yes there will be inflation, but moderate inflation which is good for business.

    And there will be less unemployment and growth on the economy, probably that is a big problem for Mr Feldstein, since he already has a job and probably is a rich guy, but for most of us, that's what the economic policy should be about.

  22. CommentedJose araujo

    Rapid monetary expansion wasn't the only thing happening in the Weimar republic or in Latin American the 80's, so it doesn't prove the point that rapid monetary expansion allways cause inflation.

    Weimar and Latin America episodes are associated with fixed currencies massive trade deficits and, which led to huge amount of debt in foreign currency, etc.

    Also here there is a case for correlation, if you expand the monetary base on growth periods, for sure you will find a correlation between monetary expansion and inflation, but you have to consider that in growth periods central banks accommodate the growth by increasing money supply.

    If a country isn't in full employment, which we aren't and rapid monetary expansion is used to fund expansionary fiscal policy, why would you have high inflation?

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