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Will Inflation be a Problem?May 4, 20091
TD Economics
WILL GUARDING AGAINST DEFLATION NOW LEAD TO ANINFLATION PROBLEM IN THE FUTURE?
May 4, 2009
Special Report
The deep economic recession currently beingexperienced in the United States is one of theworst in recent memory. Falling consumer con-fidence and a crippled banking system has in-creased the risk of deflation.•With nominal interest rates now close to 0%, theFederal Reserve has turned to non-traditionalmonetary policy in order to prevent deflation -dramatically increasing the amount of moneyavailable in the financial system.•The large increase in base-money has led tofears that the long-term consequences of Fedaction will be rampant inflation.•Inflation is not an immediate concern becausedeleveraging households have dramaticallypulled back their spending and the extra moneyis currently sitting in bank vaults.•The substantial amount of economic slack cur-rently existing in the U.S. economy limits therisks of inflation over the near-term. Empty fac-tories and rising unemployment give businessesand workers little room to bid up prices andwages.•As an economic recovery takes place and eco-nomic slack is lessened, the rise in money sup-ply could once again lead to rising prices. Inorder to prevent this the Fed must be willingand able to pull-out the liquidity it has injected.If they are not able to do this fast enough, risinginflation could be the result.
HIGHLIGHTS
FEDERAL FUNDS TARGET RATE& EFFECTIVE FED FUNDS RATE
012345Nov-07Jan-08Apr-08Jul-08Oct-08Dec-08Mar-09Effective Fed Funds RateTarget Fed Funds RatePercent* Quantitative/Credit EasingSource: Federal Reserve BoardLehman Bros. Collapse
QE/CE* 
The events of the last year have dramatically changedthe face and trajectory of the U.S. and global economies.One of the worst banking crises in history has pulled theworld into a deep recession that in length and scope al-ready weighs in among the longest and deepest in recentmemory. The unprecedented nature and synchronicity of the decline has raised fears of both deflation in the nearterm, and the possibility of rapid inflation further down theroad.In response to the risk of deflation, policy makers havetaken unprecedented action to recapitalize the global fi-nancial system, to restore confidence through expansivefiscal spending, and to ease the cost and availability of creditby lowering interest rates, injecting liquidity into financialmarkets and dramatically expanding the monetary base.These efforts have helped to pull the U.S. economy awayfrom the deflationary brink. Currently, signs are mounting
 
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Will Inflation be a Problem?May 4, 20092
simultaneous use of Fed lending and OMO allows the Fedto specifically target liquidity constrained institutions, whileat the same time maintaining the overall amount of liquidityin the system. Prior to September 2008, increased lendingby the Federal Reserve was best characterized as liquidityprovision – the Federal Reserve altered the composition(but not the size) of its balance sheet by taking on moreprivate loans and collateral and selling its holdings of treas-ury securities.
Bringing out the bazookas
As of September 2008, the Federal Reserve shifted itstactics and increased its lending provisions without offset-ting the outlays by selling government securities. In es-sence, the Fed funded its lending by creating money - al-lowing the monetary base – currency and cash reservesof commercial banks with the Federal Reserve to rise dra-matically. As a result, between August 2008 and January2009, the monetary base close to doubled from $840 billionto over $1,700 billion.Economists generally agree that inflation is essentiallycaused by an increase in the money supply. However, themonetary base is not the same thing as the “money sup-ply.” The money supply represents all of the money avail-able in the economy at any given time, including money inprivate checking and savings accounts, and under broaderdefinitions, the money sitting in money market mutual fundsthat can easily be converted into cash by its holders. Thedifference between the monetary base and the aggregatemoney supply depends importantly on the amount of lend-ing that takes place in the economy. In a system of frac-
THE U.S. MONETARY BASE
02004006008001,0001,2001,4001,6001,8002000200120022003200420052006200720082009
Monetary Base = Currency + Reservesof Depository Institutions
$U.S. Trillions*Quantitative/Credit EasingSource: Federal Reserve BoardMonetary BaseCurrencyReserves of DepositoryInstitutions
QE/CE* 
that the pace of decline is abating and the economy is slowlyinching towards recovery.Nonetheless, the extraordinary policy response and, inparticular, the increase of cash in the system has led toheightened fears that surging inflation could become thelasting legacy of this crisis. After all, basic economic theorytells us that an increase in money supply leads to higherinflation, as too much money chases too few goods. How-ever, the lingering fallout from the current financial crisisand the current deep economic downturn both suggest thatthe risk of an inflationary problem in 2009 and 2010 areremarkably low, but risks increase in 2011 and 2012.
Liquidity provision versus credit expansion
By any measure, the response by both fiscal and mon-etary policy makers to the current crisis has been immense.The goal of Federal Reserve policy is to restore the flowof credit in the economy. The Fed has relied on two policyinstruments to ease credit conditions: lowering the federalfunds rate through Open Market Operations (OMO) andincreasing their lending to financial institutions through arange of auction facilities and at the discount window.When engaging in OMO, in order to lower the fed fundsrate, the Federal Reserve uses the monetary base (cur-rency and deposits of commercial banks with the Fed) tobuy government securities. By buying government securi-ties (which then become assets of the Fed), the centralbank increases the amount of reserves in the system andexerts downward pressure on short-term interest rates. Inaddition to OMO, the Fed can also lend to financial institu-tions directly, offering cash in exchange for collateral. The
RESERVES OF DEPOSITORY INSTITUTIONS
01002003004005006007008009001,000Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09 Mar-09Excess ReservesRequired ReservesU.S. $BillionsSource: Federal Reserve
 
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Will Inflation be a Problem?May 4, 20093
tional reserve banking, banks lend out all but a small por-tion of the deposits they receive from the public. As bankslend out their excess reserves, these loans become depos-its for other financial institutions. This process then car-ries on down the line.However, if there is an increase in reserves and thecommercial banks do not lend out the additional funds, theaggregate money supply will not grow despite the increasein the monetary base. In order to maintain the federal fundsrate close to its target at 0.0-0.25%, the Federal Reservehas been paying a 0.25% rate of interest on the excessreserves that commercial banks hold with them. Currently,a large number of commercial banks would rather earnthis negligible risk-free rate than lend the funds out be-cause their balance sheets are so weak. Since the Fed hasbeen adding reserves to the system, the excess reservesof commercial banks have grown from $1.9 billion in Au-gust 2008 to $798 billion in January 2009. As a result of this hording, the multiplier of the monetary base to thebroader money supply (M2) has fallen dramatically from9.3 to 5.1.
1
Accordingly, the increase in the monetary baseis not as inflationary as it looks at face value.
Inflation and the velocity of money
Yet another reason that inflationary pressures have notyet arisen in the economy is that the decline in spendinghas reduced the rate at which money changes hands. Nomi-nal GDP equals the current dollar value of production inthe economy – that is, the quantity of production multipliedby the current price. Since nominal GDP is equal to totalexpenditure, it must also equal the total amount of moneymultiplied by the number of transactions. If for any givenamount of money, the number of transactions falls, the re-sult would be a decline in total expenditures or nominalGDP. Economists call the frequency of money transac-tions the velocity of money.
2
Inflation, broadly speaking, is the increase in prices inthe economy.
3
The change in prices is positively related tothe change in money supply and any increase in the circu-lation of money, and negatively to the rate of change of real output. If the money supply increases, while every-thing else is unchanged, this should be expected to result inhigher prices. But if, on the other hand, the money supplyincreases, but the increase takes place alongside a fall inthe circulation of money (or a rise in real output), pricesmay not increase at all, or in extreme cases may actuallyfall (deflation).In the current environment, the fall in the circulation of money reflects the increased preference of households forliquid assets and the decline in the availability of credit.The loss in household wealth has led to an increase in thehousehold savings rate, which in combination with increasedrisk aversion in financial markets has led to outlays fromriskier financial assets and into either government bondsor cash. At very low interest rates, the difference betweenthe return on risk-free government bonds and cash is verysmall, raising the appeal of cash holdings.The takeaway from all this is simple: if lenders won’tlend and borrowers won’t borrow, the rise in the monetarybase will not result in inflation.
Economic slack and price pressures
While these considerations have focused on the dynam-
THE VELOCITY OF MONEY*
1.51.61.71.81.92.02.12.219591964196919741979198419891994199920042009*Velocity = Nominal GDP / M2Source: BEA, Federal Reserve
M2 MONEY MULTIPLIER*
4567891011121319591964196919741979198419891994199920042009*Money Multiplier = M2/Monetary Base. M2 = Currency + CheckingDeposits + Savings Deposits+Time Deposits (< $100,000)Source: Federal Reserve
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