A commonly expressed concern regarding the Federal Reserve's recent policy actions is by increasing money supply the Federal Reserve is stoking the fires of inflation once the recovery starts. This statement could be true in a limited set of circumstances. However, the far more probable scenario is the increased money supply will not lead to increased inflation. Let's look at the reasons why.
Before we move further there are two relevant points. The first is some of he information contained in this article is based on a booklet originally issued by the Chicago Federal Reserve titled, "Modern Money Mechanics." While it is no longer available from the Chicago Fed it is available by searching the Internet for the title "Modern Money Mechanics." Secondly, this article is a joint effort with a friend who -- for professional reasons -- must remain anonymous (various links refer to his pseudonymous work elsewhere).
First, let's look at the data of money supply to see what is actually happening. Here is a chart from the St. Louis Federal Reserve of M2:
This is in logarithmic scale with a circle around the last few years of activity. Notice how the recent money creation registers an increase, but not one of monumental proportions; it is hardly out of line with other increases that occurred over the last 30 years.
Secondly, let's take a look at the rate of change in the money supply:
This is the year over year rate of change in M2. Notice how the US experienced a higher year over year rate of change at the end of the early 1980s double dip recession and during the last recession. In other words, the current rate of growth in the money supply is hardly out of line with historical experience.
Finally there is the broadest measure of money supply M3. Unfortunately the government no longer maintains this monetary aggregate. However, Shadow Stats does. Here is their chart:
Notice how the rate of change has been decreasing since the beginning of 2008. Also notice that according to this chart, M1 has been increasing. However, remember that M2 and M3 each include M1 in their calculations. So the increase in M1 -- which is essentially physical currency -- is already factored into the M2 and M3 charts. The fact that M1 has been increasing indicates the Federal Reserve has been doing everything it can to get physical currency into the economy in order for people to spend it.
But just because the Federal Reserve is printing money does not mean we are spending it. The rate at which consumers spend their money is called velocity, which is "A term used to describe the rate at which money is exchanged from one transaction to another." Here is a chart of US monetary velocity:
The circle is around the latest time period. Notice how velocity -- the rate at which money goes through the economy -- has dropped at a sharp rate. This indicates that despite the increase in M1 (physical currency) people are spending it at a slower rate.
Let's tie this information into the official inflation rate. Here is a chart of velocity and CPI.
Above is a chart of velocity and CPI. Notice there are three periods. The first occurs from the end of 1959 to roughly the beginning of the 1990s. During this period velocity and inflation were highly correlated -- an increase in velocity meant an increase in inflation and a decrease in velocity meant a decrease in inflation. However, that relationship stopped for roughly 10 years from 1993 to 2003. The reason for this "decoupling" was the Internet/technology boom during that period. It allowed an increase in velocity to not have any impact on CPI. However, starting again in 2003 we see an a return to that correlation where an increase in velocity leads to an increase in inflation. That means that as velocity drops we are more likely to have a decrease in overall CPI -- which is demonstrated by the current chart.
Keep in mind the most fundamental definition of inflation: Too much money chasing too few goods. Now consider that the collective household balance sheet of America has shrunk over the last six quarters by some $13 trillion dollars, and will almost certainly decline further when the next Fed Flow of Funds report is released in a few weeks. (It is in this context -- the massive shrinkage of the American balance sheet -- that the Fed's money creation should be considered.) Keep in mind too the massive deleveraging that began last year and that will likely continue for some time to come. The San Francisco Fed highlighted this trend in a recent report. Ongoing changes in spending habits and attitudes toward credit itself are going to be secular -- not cyclical -- in nature. These are deflationary, not inflationary, changes (particularly in view of the fact that the U.S. consumer has been roughly 70 percent of GDP). There have been myriad stories written about the new "thrift" and "frugality" of the American consumer, and this change will be measured in years, not months or even quarters (this report foretold our Frugal Future). Hence these quotes from the most recent FOMC minutes: "Most participants expected inflation to remain subdued over the next few years, and they saw some risk that elevated unemployment and low capacity utilization could cause inflation to remain persistently below the rates that they judged as most consistent with sustainable economic growth and price stability." And this: "All [participants] anticipated that unemployment, though declining in coming years, would remain well above its longer-run sustainable rate at the end of 2011; most indicated they expected the economy to take five or six years to converge to a longer-run path characterized by a sustainable rate of output growth and by rates of unemployment and inflation consistent with the Federal Reserve's dual objectives, but several said full convergence would take longer."
Let's sum up so far. While M2 has increased in total and on a year over year basis, the increase is in line with historical experience. We saw a sharper increase in M2 at the end of the early 1980s and early 2000s recession. Finally, the direct relationship between and increase or decrease in velocity and inflation has returned along with a massive drop-off in velocity. This means we've seen a big drop-off in inflation.
Now, onto the issue of money creation. There has been a constant refrain that the Fed is printing money like there's no tomorrow. What these statements forget is they are temporary. Here's why. The Federal Reserve has essentially propped up most debt markets through their programs like the Commercial Paper Funding Facility, and the Term Asset Backed Securities Loan Facility along with several other programs. Through these facilities the Federal Reserve is essentially propping up several markets that were frozen because of the credit crisis. For those of you who are interested, the Wall Street Journal looks at the Fed's balance sheet every week.
These facilities create money. Here's how it works. When the Federal Reserve purchases a security it credits the seller's account. This increases the seller's reserves -- reserves against which he can now make loans and increase the money supply. However, let's remember an incredibly important -- and easily forgotten -- point. These Fed facilities are temporary; they will end one day. They started because of the Credit Crisis. As the credit crisis eases The Fed will start to sell these securities back to credit market participants As the do so they will "mop up" the excess reserves in the system. "Mopping up" means when Fed sells the securities to market participants the market participants will have to pay for the securities. That means the market participants will have to decrease their reserves, thereby lowering the amount of money they have available for loans, thereby shrinking the money supply. While it is true the Fed has never had to mop up as much liquidity as we have right now, that does not mean they can't do it. It simply means it will be a bigger job.
So to wrap up we have the following points.
1.) Absolute M2 is increasing but in line with current experience.
2.) The year over year percentage change increase in M2 is lower than the previous two recessions.
3.) M3 -- a larger monetary measure than M2 -- has actually decreased.
4.) Velocity is way down, indicating that the rate at which people spend money is decreasing at a fast rate.
5.) While the Fed has increased the monetary supply, they will mop up the excess liquidity as they wind down their programs -- all of which are temporary.
Simply put, monetary based inflation isn't a problem right now.