Why Is US Inflation So Low?

Jun 28, 2013 Martin Feldstein

The main reason why quantitative easing has coexisted with price stability in the US is that, since 2008, the Fed has paid interest on commercial banks' excess reserves, which previously would have been lent to businesses and households. That is why investors are right to be worried about higher inflation as demand picks up.

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%.

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Martin Feldstein

Writing for PS since 2008
129 Commentaries

Martin Feldstein was Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research. He chaired President Ronald Reagan’s Council of Economic Advisers from 1982 to 1984. In 2006, he was appointed to President Bush's Foreign Intelligence Advisory Board, and, in 2009, was appointed to President Obama's Economic Recovery Advisory Board. He was also on the board of directors of the Council on Foreign Relations, the Trilateral Commission, and the Group of 30, a non-profit, international body that seeks greater understanding of global economic issues.

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0 Comments on this paragraph, 34 Comments on this article

Nilson B. Nunes Feb 22, 2017

Dear Professor Martin Feldstein
Only now we have access to your article. And, we know that inflation rates are not hot topics in the US today.
I ask Mr. what is the counterpart of the interest rate that the Federal Reserve pays to the "excess reserves" deposited by the Commercial Banks?
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Jeong Takyoung Mar 19, 2015

Textbook explanation. Well understood.
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Bob Bill Nov 17, 2014

PLus, that URL does not work. Get your typing right and get a big fat pig for your birthday.
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Bob Bill Nov 17, 2014

Parrain boursoramsa, I believe that you do not provide a good argument for your argument. And yes, inflation does come from too much money.. Get a life...
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Bob Bill Nov 16, 2014

I believe this is all nonsense... We should just move to a communist country and abandon this corrupted society and economy.
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Parrain Boursorama Jan 12, 2014

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
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Parrain Boursorama Jan 12, 2014

http://www.project-syndicate.org/commentary/germany-s-taxpayers-finance-german-banks--mistakes-by-luigi-zingales
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Jared Hansen Jul 25, 2013

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.
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Barry DeCicco Jul 25, 2013

Noah Smith has a counter-argument:

http://noahpinionblog.blogspot.com/2013/07/is-interest-rate-on-reserves-holding.html
(Recommended by Paul 'Correcto' Krugman)
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Ralph Musgrave Jul 25, 2013

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
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Kenneth Duda Jul 25, 2013

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.
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Christopher Lemieux Jul 8, 2013

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.
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Heriberto Arribas Jul 5, 2013

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.
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Jeremy Sparks Jul 4, 2013

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!
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Pepe Bell Jul 3, 2013

Basicly it means that there is no high inflation (yet) because the money generated by the FED is not in circulation.
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Ernest Jack Jul 2, 2013

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.
- Christopher Lemieux Jul 8, 2013
  
  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.
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- Adam Harper Jul 3, 2013
  
  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.
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Scott Swift Jul 1, 2013

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.
- Jose araujo Jul 2, 2013
  
  Inflation is in fact low, no matter which sources you use. The problem is that we are all making less money :-(.
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Procyon Mukherjee Jul 1, 2013

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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Alexander Shadow Jun 29, 2013

Why Are Banks Holding So Many Excess Reserves?
Explains here:
http://www.newyorkfed.org/research/staff_reports/sr380.pdf
- Procyon Mukherjee Jul 1, 2013
  
  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.
  A new reply to this comment has been posted.
- Tomas Kurian Jun 30, 2013
  
  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.
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Aurelian Dochia Jun 29, 2013

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?
- Ahmet Ihsan Kaya Jun 30, 2013
  
  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.
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Frank O'Callaghan Jun 29, 2013

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.
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Stephen Griffin Jun 28, 2013

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.
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Alex R. Mumm Jun 28, 2013

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?
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Eduardo Moron Jun 28, 2013

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.
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Jose araujo Jun 28, 2013

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.
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Jose araujo Jun 28, 2013

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.
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Jose araujo Jun 28, 2013

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.
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Jose araujo Jun 28, 2013

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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