Fed Policy Effect on Inflation – Yes

If the question is whether the Federal Reserve today is indeed laying the groundwork for the U.S. economy to experience future inflation, by expanding its balance sheet to fight systemic risk in Global Finance, the answer is yes. However, this is not necessarily a bad thing and cannot be considered a “bubble” as such until all the data are in. I would also prefer not to use the term “inflationary bubble” as it is decidedly ambiguous: inflation refers to a sustained rate of increase in the price of goods and services while bubble refers to an unusually high relative price of a single asset type.

We must recognize that debilitating inflation has not struck the U.S. economy yet, nor has it shown any indication that it will rear its ugly head in the short term, say over the next year or so. The reason why the Fed’s action will create inflation in the longer term is that banks will eventually lend the money they have received from the Fed, especially once economic growth resumes. However, banks have learned their lesson from the sub-prime mortgage fiasco and have ratcheted up credit restrictions so that not just anyone can be offered a loan now. The fact of banks NOT lending during the credit crunch which began in September 2008 means that less money has been circulating in the economy and deflationary pressures have been gathering.

And while banks are indeed pocketing the capital infusion so generously offered by the U.S. Treasury, they will soon need to lend that money in order to make a profit at what they do for a living. This bank recapitalization may have decreased the banks’ leverage ratios in the short term, but finding useful ways to employ those excess reserves is the popular will of the American people and seemingly inevitable. To be fair to the “Fed,” they likely will not need to act to decrease the money supply and fight inflation until banks deploy more of their capital and restart the engine of the American economy.

So yes, while the Fed’s actions over the past four months have been unprecedented in scope and hastily put together, with the fundamental effect of creating inflation over the medium term, they still have range of action to act on behalf of fighting inflation, the inevitable result of current policy action.

The bottom line is this: “Inflation is always and everywhere a monetary phenomenon” – Milton Friedman. This is the economists’ way of saying that increasing the money supply during no growth will cause inflation.