Yesterday, I wrote a post about why startups and VCs should care about whether inflation is a real threat and promised a follow-up about some of the arguments floating around.  The eye-popping chart that prompts one line of reasoning is this:

After 40 years of growth in the 0-10% range (with a brief spike in 2000), the monetary base jumped by 110% 2008-2009.   In absolute numbers, the monetary base went from a bit below $1 trillion to a bit over $2 trillion.  What exactly is the monetary base?  It is currency in circulation (and in vaults) and reserves held by banks at the Fed.  Both of these constitute the liability side of the Federal Reserve’s balance sheet.  Conversely, reserves at the Fed appear on the asset side of commercial banks.  That’s of course also where loans appear.  So how does this potentially translate into inflation?  If banks draw down their Fed reserves and lend the money out, then there is a lot more money out there.

That explains why we don’t face an immediate inflation threat from this explosion in Fed reserves: banks simply aren’t lending.  We are, as Krugman pointed out, in a liquidity trap.  The obvious question then is, but what about when the economy recovers?  Won’t banks then draw down their reserves and start lending like crazy?  The answer to this turns out to be a bit trickier.  The Fed has two fundamental options here.  First, it can try to reduce the reserves by various mechanisms, such as selling assets which would shrink the size of the Fed’s balance sheet.  One potential problem with this is that some of the stuff on the Fed’s balance sheet may not find any takers!  As this nice chart shows, there is $100 billion or so in junk from AIG and Bear and another $400 billion in mortgage backed securities.  The second option is for the Fed to start paying interest on Fed reserves.  This is something that, for instance, New Zealand does.  Obviously, if a commercial bank can earn interest by keeping money at the Fed with zero risk, there is no incentive to lend that money out!  Janet Yellen, the President and CEO of the San Francisco Fed summarized both options in a recent speech:

The simplest approach—the one that we have used traditionally—would be to shrink our balance sheet by selling the Treasuries, agency debt, and agency MBS we accumulated during the crisis. Many of the special liquidity and credit facilities we have developed will be phased out as financial markets recover. But it is conceivable that, even with the economy rebounding nicely, the credit crunch might not be fully behind us and some financial markets might still need Fed support. In this case, we could increase the interest rate we pay on bank reserves.

Bottom line, as far as I can tell, the Fed does have lots of tools available to reduce or neutralize these huge reserves, but they will have to use them at the right time and to the right degree or there could be a big jump in lending down the line which would result in inflation.  So nothing imminent but worth watching.  Now this post has already run on for quite some length and that means I will “reserve” another way that we might be headed for inflation for a Part 3.

Yesterday, I wrote a post about why startups and VCs should care about whether inflation is a real threat and promised a follow-up about some of the arguments floating around.  The eye-popping chart that prompts one line of reasoning is this:

After 40 years of growth in the 0-10% range (with a brief spike in 2000), the monetary base jumped by 110% 2008-2009.   In absolute numbers, the monetary base went from a bit below $1 trillion to a bit over $2 trillion.  What exactly is the monetary base?  It is currency in circulation (and in vaults) and reserves held by banks at the Fed.  Both of these constitute the liability side of the Federal Reserve’s balance sheet.  Conversely, reserves at the Fed appear on the asset side of commercial banks.  That’s of course also where loans appear.  So how does this potentially translate into inflation?  If banks draw down their Fed reserves and lend the money out, then there is a lot more money out there.

That explains why we don’t face an immediate inflation threat from this explosion in Fed reserves: banks simply aren’t lending.  We are, as Krugman pointed out, in a liquidity trap.  The obvious question then is, but what about when the economy recovers?  Won’t banks then draw down their reserves and start lending like crazy?  The answer to this turns out to be a bit trickier.  The Fed has two fundamental options here.  First, it can try to reduce the reserves by various mechanisms, such as selling assets which would shrink the size of the Fed’s balance sheet.  One potential problem with this is that some of the stuff on the Fed’s balance sheet may not find any takers!  As this nice chart shows, there is $100 billion or so in junk from AIG and Bear and another $400 billion in mortgage backed securities.  The second option is for the Fed to start paying interest on Fed reserves.  This is something that, for instance, New Zealand does.  Obviously, if a commercial bank can earn interest by keeping money at the Fed with zero risk, there is no incentive to lend that money out!  Janet Yellen, the President and CEO of the San Francisco Fed summarized both options in a recent speech:

The simplest approach—the one that we have used traditionally—would be to shrink our balance sheet by selling the Treasuries, agency debt, and agency MBS we accumulated during the crisis. Many of the special liquidity and credit facilities we have developed will be phased out as financial markets recover. But it is conceivable that, even with the economy rebounding nicely, the credit crunch might not be fully behind us and some financial markets might still need Fed support. In this case, we could increase the interest rate we pay on bank reserves.

Bottom line, as far as I can tell, the Fed does have lots of tools available to reduce or neutralize these huge reserves, but they will have to use them at the right time and to the right degree or there could be a big jump in lending down the line which would result in inflation.  So nothing imminent but worth watching.  Now this post has already run on for quite some length and that means I will “reserve” another way that we might be headed for inflation for a Part 3.