The Spectre of Price Inflation

Inflation was said to be a temporary blip during Covid. In this new book by Agenda Publishing, and Columbia University Press in the US, I go through the history of money and banking policy, how inflation episodes have occurred and why this inflation increase of 2021-2022 is likely to be more of an episode as in the 1970s than a quick blip in the economic landscape.

I describe how the conflation of monetary policy designed to target a low inflation rate became obstructed by central banks conducting banking insurance policy, after the bank crash of 2008. By subsidizing private banks to avoid financial collapse after 2008, central banks began fixing short term market interest rates below the inflation rate for all but three of the last twenty years. This occurred in the US when the Federal Reserve moved up to 2008 during the crisis a policy of paying interest on “required reserves” that was to take place in 2011. Then the Fed instead paid interest on ALL reserves held at the Fed.

Instead of the zero excess reserves held at the Fed in all previous modern history before 2008, reserves built up at the Fed almost exactly to the amount of new money that the Fed created by buying Treasury debt, up to September of 2014 as in the below graph from the Federal Reserve Bank of St. Louis (FRED).

This increased money supply from 2008 to 2014 was as a result completely “sterilized”: meaning the private banks were paid not to lend out the reserves and the reserves stayed in place at the Fed. This new money, manifested by the build up of new reserves, followed almost exactly in line with the money printed by the Fed buying Treasury debt from the private banks. Normally, banks lend out all reserves as soon as possible and hold zero excess reserves, as was the case before 2008.

The disconnect between the money supply growth and the inflation rate then appeared. Since nearly all of this new money creation after 2008 until 2014 did not enter circulation, which is the key to causing inflation, the inflation rate did not rise.

Once the reserves began to be lent out, the money entered circulation. If you study the graph, it is clear that after 2014 the reserves began falling, thereby entering circulation. This happened as the Fed started in December 2015 to raise the interest rate paid on reserves. This rate was thought to create a floor on interest rates. But because of the “fungibility” of money, the Fed-diktat interest rate on reserves also became the interest rate on the 3-month Treasury bill, and on the Federal funds rate, not to mention also the 1-year Treasury bill rate being very close as well.

This Fed policy was meant to build up a reserve pot of bank insurance money at the Fed, since the investment banks that failed in 2008 were not part of the Federal Deposit Insurance Corporation (FDIC) and their money market funds were not FDIC insured. The Fed in effect supplied an unending subsidy to private banks as bank insurance after the investment bank sector collapsed in 2008, just like getting insurance paid out to you for a car crash that you had while being uninsured!

The subsidy was the interest paid on these reserves. And the Fed also bought up the class of assets that caused the investment banks to collapse: the Mortgage-backed Securities (MBS) by billions of dollars. By conflating monetary policy with bank insurance supplied after the crash, the Fed bought huge swaths of Treasury debt, increased the money supply dramatically, sterilized the increase in money supply up to 2014 completely, set international short term market interest rates below the inflation rate, induced internationally adopted negative real interest rates on short term Treasury debt, distorted capital markets, paid banks not to lend out money for investment, and so created the moral hazard of a poorly designed after-the-crash bank insurance policy that induced less investment and greater financial risk undertaking.

The latter resulted from portfolio managers taking on greater risk/great yield assets to offset the negative return on the “risk-free” US Treasury debt. This is also why MBS were bought up by a triple-fold amount after 2001: because the Fed forced down the market interest rates by flooding the market with new money after the 2001 terrorist attacks. But they did this from 2002-2004, causing three years of negative real Treasury interest rates, inducing the flight towards MBS. Then the Fed decided to quickly “normalize” market interest rates and induced the Federal Funds rate up from 1.0% in 2004 to 5.24% in 2006, causing mass default on mortgages and the onset of the collapse of MBS that investment banks were holding to avoid the negative Treasury interest rates, and the collapse of investment banks in 2008.

After 2008, the Fed then set by diktat the interest rates in international capital markets. Why international? Because main Western economies emulated US policy in order to induce the same negative short run real interest rates so that their currencies would not appreciate relative to the US dollar.

This distorted international capital markets by inducing greater risk being invested in so as to balance the return on portfolios internationally. The moral hazard is that the international financial system has been “seeking yield” through riskier portfolios while expecting to be bailed out if a financial crisis occurs. This is in lieu of having an efficient bank deposit insurance system put in place systematically before the crisis.

The Spectre of Price Inflation explains this background and how the inflation rate rose as the money held as reserves entered circulation, very quickly after 2020, as can be seen in the graph above. The book sets out how efficient banking insurance can be set up potentially. This would enable an untangling of monetary policy and banking insurance policy that now goes by the name of macroprudential policy.

Then the central banks could go back to their objective of targeting a low inflation rate and avoid meddling in and subsidizing banks in order to supply very inefficient bank insurance that distorts global capital markets. The Fed had suppressed inflation as long as the private bank reserves stayed at the Fed, so they achieved their low inflation target up to 2018. But then this same strategy failed after 2020 when the Fed printed money (Treasury debt held by the Fed) at a dramatically accelerated rate. This increase money flooded from reserves into circulation and drove up the money supply and the inflation rate, just as the age-old quantity theory of money predicts.

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