How the US Got its Inflation

Here we present the graph showing the amount of US money that actually entered circulation since 2003. Gathering the data from the Federal Reserve Bank of St. Louis economic data base called FRED, the graph shows in the dashed black line this amount of money that entered circulation. It equals the amount of money that was printed by the Fed as they bought Treasury debt and, since 2008, Mortgage backed securities (MBS), that first entered as reserves held at the Fed and subsequently entered circulation when the reserves were lent out.

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The total assets of the Fed is given in the blue line that is in large the sum of the Treasury debt the Fed bought (solid black line) and the MBS (red line). The money that entered circulation is the total assets of the Fed (blue) minus the reserves (green), which gives the dashed black line. This line coincides almost exactly with the Treasury debt bought by the Fed (solid black) and with the total assets of the Fed (blue), before 2008 but not after 2008. The required reserves before 2008 are shown in the green line near to zero on the horizontal axis.

In 2008, after the Fed began skirting the Congressional Budget Reconciliation Act of 1974 by directly buying mortgage-backed securities, which by the Federal Credit Reform Act of 1990 have to be approved as loan purchases in the annual Congressional budget process, the Fed also skirted another law and began paying interest on all reserves.

The interest rate paid on reserves was authorized by the Financial Services Deregulatory Relief Act of 2006, but this was designed only for required reserves and legislated to become effective in 2011. The legislative history is clear that the idea was to pay interest on required reserves so that small banks were not penalized relative to large banks, since small banks had a larger proportion of their deposits held as reserves as compared to large banks. And the required reserves earned no interest. So the deregulation was to level the field slightly between small and large banks by paying interest on required reserves, but not on all reserves. Unfortunately, the law as written says it allows the Fed to pay “interest on reserves”. It should have read “interest on required reserves”, but it would be fair to say that no one envisioned (except the Fed itself perhaps) that this interest would ever be paid on all reserves.

The Fed took advantage of the wording of the 2006 Act, had the effective date moved up to 2008, and instead paid interest on all reserves. The green line shows that reserves built up almost exactly in line with the Treasury debt bought by the Fed. This sterilized the money creation of the Fed by leaving it in the coffers of the Fed, in the accounts of the large banks that sold the Treasury debt to the Fed and then left this in the Fed: This account at the Fed for the banks is called their “reserves.” Getting paid not to lend out these reserves, the reserves built up until 2014. And the Fed could claim it met its self-proclaimed inflation rate target of 2%, implying that their policy was successful.

However, once the Fed began raising the interest rate on reserves, the private banks began lending out this money held at the Fed and the reserves began entering circulation.

The dashed line shows that the amount of newly printed Fed money entering circulation is growing largely at a rate up to 2014 as it had in all previous history. But then the dashed line slopes up after 2015 as reserves enter circulation at a faster rate. Inflation remained moderate but increased from 0% in January 2015 to 2.5% two years later in January 2017.

However, the money entering circulation (black dashed line) shoots up beginning in 2020. Even though reserves built up even higher than their September 2014 peak of $2.8 trillion, to $4.2 trillion in September 2021, the Fed bought so much Treasury debt and MBS after 2020 that the money entered circulation at a hugely accelerated rate.

The quantity theory of money is well alive. As the Fed-printed money entered circulation at a dramatically accelerated rate, the US inflation rate rose dramatically after 2020. When the new money supply was effectively sterilized by banks holding it as reserves in their accounts at the Fed from 2008 to 2014, the money supply grew but the money supply that entered circulation did not grow much because it remained as reserves at the Fed. After 2020, the US Treasury borrowed so much to cover Treasury deficits, which rose above 10% of GDP, that the Treasury debt to GDP ratio rose dramatically, from 107% of GDP in the first quarter of 2020 to 134% of GDP in the second quarter of 2020. As in most major crises, the Fed helped out by buying large swathes of the new Treasury debt. After 2020, this time the new money did not all stay sterilized as reserves held at the Fed. Rather much of it was lent out, the money in circulation surged upwards, and the inflation rate followed with its surge upwards.

This is how the US got its inflation.

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