Martin Feldstein: Fed Policy & Inflation Risk
CAMBRIDGE - During the past four years, the United States Federal Reserve has added enormous liquidity to the US commercial banking system, and thus to the American economy. Many observers worry that this liquidity will lead in the future to a rapid increase in the volume of bank credit, causing a brisk rise in the money supply - and of the subsequent rate of inflation.
That risk is real, but it is not inevitable, because the relationship between the reserves held at the Fed and the subsequent stock of money and credit is no longer what it used to be. The explosion of reserves has not fueled inflation yet, and the large volume of reserves could in principle be reversed later. But reversing that liquidity may be politically difficult, as well as technically challenging.
Anyone concerned about inflation has to focus on the volume of reserves being created by the Fed. Traditionally, the volume of bank deposits that constitute the broad money supply has increased in proportion to the amount of reserves that the commercial banks had available. Increases in the stock of money have generally led, over multiyear periods, to increases in the price level. Therefore, faster growth of reserves led to faster growth of the money supply - and on to a higher rate of inflation. The Fed in effect controlled - or sometimes failed to control - inflation by limiting the rate of growth of reserves.
The Fed began an aggressive policy of quantitative easing in the summer of 2008 at the height of the economic and financial crisis. The total volume of reserves had remained virtually unchanged during the previous decade, varying between US$40 billion and US$50 billion. It then doubled between August and September of 2008, and exploded to more than US$800 billion a year later. By June of 2011, the volume of reserves stood at US$1.6 trillion, and has since remained at that level.