This article comments on the unfounded conspiracy theory held by inflation pessimists that the Federal Reserve’s increased lending will invariably trigger massive future inflation.
To provide a crutch for the ailing banks that overextended themselves during the Millennium Housing Boom by making too many high-risk real estate loans, the Federal Reserve (the Fed) infused massive amounts of new money into the banking system. After supplying banks with cash starting in October 2008 after the near collapse of the lending industry, the Fed made additional (new) funds available to banks (as borrowers) for all types of lending, such as homeowner purchase-assist loans and commercial refinancing.
The result was a deliberate, and so far successful, stabilization of the banking industry. It did not and cannot make insolvent banks suddenly solvent. Bad paper is still bad paper. However, as has historically been the case whenever the Fed pumps large amounts of money into the economy, inflation pessimists emerge. These economic charlatans often and loudly proclaim (with no historical or justifiable proof) that the Fed’s healing actions will tangentially cause alarmingly high inflation.
We deliberately are given 2% to 3% annual inflation as a “hedge” against deflation since deflation is virulent and far more difficult to root out than inflation. Thus, these inflation pessimists say, the pumping of new money will eventually prove economically damaging, a debunked economic platform constantly energized by mid-American “fresh water” economists. “Government interference is the problem, not the solution,” roars the chorus of Reganomics. Few Californians are fooled.
As discussed in a recent speech titled “On the Economic Outlook and the Commitment to Price Stability” delivered by Dennis P. Lockhart, President and Chief Executive Officer of the Federal Reserve Bank of Atlanta, the inflation pessimists’ battle cry is without merit or substance. We at first tuesday can only hope the12th District Federal Reserve President would be as gutsy.
The argument heralded by inflation pessimists is of limited depth and ignores many fundamental changes to the Fed’s monetary policy. They believe the growth of the federal deficit, in tandem with the calculated growth of the Fed’s balance sheet as it funnels money to ailing banks, invariably sets the stage for future inflationary trends of leviathan proportions – equal in size to the pump priming that has been carried out. Under inflation pessimists’ reasoning, as people begin to borrow and spend yet again, banks will withdraw their substantial cash reserves on deposit with the Fed to make an increased volume of loans in tandem with the increase in consumer confidence. As a result, too much money will be available to chase too few goods and services which will drive up prices – hence, inflation.
Thus, the pessimists superficially conclude that the necessary growth in the money supply (the very same supply which kept the largest banks from sinking irretrievably into insolvency) has no other course of action but to cause inflation. And even more horrific, they predict the inflationary movement will start very soon and stamp out the economy that has only just begun to recover.
However, this foregone conclusion is ignorant of protective actions already taken by the Fed to avoid the exact inflationary doomsday scenario feared by the pessimists. Since October 2008, the very moment when the Fed began funneling cheap money to banks, the Fed has been paying interest on the funds held by the banks as reserves on deposit with the Fed, an unprecedented action which was not previously the Fed’s policy. As a result, banks are less inclined to loan out their interest-bearing reserves or actively seek ways to invest their easy capital; instead, they have more impetus to wait patiently, holding onto those massive golden reserves, collecting interest and appearing solvent in the process.
Thus, the size of the Fed’s balance sheet (the product of lending), though necessarily very large, does not mean future inflation is inevitable. There will be no flood of cash available to consumers since it is not in the best interest of banks to open the floodgates as permitted by their reserves, as is the presumption of the inflation pessimists.
Contrary to the pessimists’ fears, the Federal Open Market Committee (FOMC), a component of the Fed designated with overseeing the open market monetary operations of the nation, is fully conscious of the potential for inflation. Inflation fighting is the Fed’s primary job, together with job growth. The Fed has a control system for removing the funds systematically. The pessimists, it seems, are quick to forget a basic monetary principal: what the Fed puts in, the Fed always gets back, both at a time of its choosing.
The FOMC expects the size of the Fed’s balance sheet (money lent) will peak towards the end of 2009. After it has reached its apex, it will decrease as their long-term lending programs are completed, intentionally phased out, or not needed as banks regain their independent stability. When inflation begins to reappear, the FOMC has long-standing mechanisms that will reduce the Fed’s balance sheet (money lent) in a controlled, regulated way which will not hinder the natural growth of the economy. They conduct in-and-out adventures on their balance sheet every commercial (Christmas) season, and also did so going into 2000 to alleviate the millennium panic’s demand for cash from individuals.
Unfortunately, the inflation pessimists’ concerns are as vociferous are they are unsubstantiated – a dangerous combination. As surmised by Lockhart, inflation fears can quickly become inflation expectations, a self-fulfilling prophesy of the most nefarious kind. Deflationary expectations, held by businesses and consumers alike going into 2009, is a bane to economic recovery since deflation is tough to eradicate. Deflation is perhaps the greatest menace threatening the Fed’s ability to act unhindered in efforts to stabilize the economy, in good times and in bad. Currently, the chances of inflation are no more likely than the chances of deflation, as real estate service providers (read: brokers and their agents) will come to realize over the next three or four years.
The Fed is the sole entity entrusted with pulling back the funds they injected into the banking system. To maintain a reasonable long-term expectation of inflation among holders of dollars and dollar-denominated assets (read: real estate), the Fed must absorb the funds before prices of consumer goods rise more than 2 or 3% annually (it’s currently just below 2%).
Looking towards the future, the Fed must learn from its mistake of keeping interest rates low for too long, as it did during the 1990s and again during the Millennium Boom, and reexamine its dismissive attitude toward leaning against recurring asset inflation. When a future similar stage for financial instability is set as the stock market and real estate prices begin their next seemingly inevitable (speculative) ascent, the Fed, unlike its past behavior, must act quickly to preempt yet another boom and bust cycle. [See our Preventing the next real estate bubble article from the October 2009 journal.]
More precisely, when prices on both types of investment assets rise more than 4-5% per annum — starting with stocks then moving to real estate — the Fed must increase short-term rates, and possibly sell long-term bonds discounted at high rates of interest. Thus, it must suck up money to make the dollar more dear and scarce, all in an effort to install a controlling damper on unsustainable asset inflation and rid us of the violence of booms. This the Fed can do as part of its inflation fighting and job stabilization authority. The Fed coordinates this task in concert with the administration, which then cuts down government spending, and Congress, which can increase taxes. It has all been done before.
The Fed should also use its influence to push regulatory agencies and Congress, as it did under Greenspan, to regulate the risks a mortgage lender can reasonably take (down payment amounts, terms of the loan, type of appraisal – cost, income, and comparable approaches, repayment schedules, variable teaser rates, etc.). And while these regulatory measures will likely be met with resistance and scorn in the future by the same preachers of an inflation doomsday that never came and at a time when money is being made by all, it is the responsibility of the Fed to be forward-looking (and realistically pessimistic if need be) even in the face of those optimistic boom years.
It is excess money that intoxicates behavior more than any pharmaceutical or alcohol, and it’s a difficult and unpopular call to pull the money back and shut a party down just as it gets going, not wait until it has gone wild – but that’s the purpose and nearly 100-year history of the Fed.