Mainstream media sources such as the New York Times tend to make light of policies such as QE1, 2, and 3 (the processes of printing money to buy US treasury bonds), asserting that there have been no signs of high inflation, despite three rounds of massive increases in the money supply.
While inflation hasn’t made its way to the grocery store, it has been credited to the government’s and the FDIC banks’ accounts. It’s also paid a visit to the investor-class in the form of inflated asset prices, giving investors the opportunity to borrow for leverage in stocks, real estates, and of late, in cryptocurrencies. In effect, asset prices are bid up to dangerously overvalued levels.
In 2014, St. Louis Fed (FRED) economists wrote an article claiming that the reason for low inflation in consumer prices was due to a scheme called the Keynesian liquidity trap. This is a situation in which the supply of reserves in banks are increased through each round of quantitative easing. They are increased to the extent that it intersects with demand at a federal funds rate hovering just above zero. This acts as a binding price floor, and shields banks against a negative federal funds rate. How? Banks prefer instead to lend to the Fed at the interest on reserves (IOR) rate, rather than to lend to other banks at a negative federal funds rate. Out of self-interest, banks will choose to earn interest from the Fed at a positive rate, rather than be forced to pay borrowers, following a negative rate. What the FRED economists failed to consider were savings and investment decisions based on real rates, not nominal rates.
As pointed out in an article by the Mises Institute, European and Japanese central bank have already pushed their federal funds rate below zero, which means that something else is responsible for the mass of excess reserves. Before it was used in 2006, excess reserves were practically nonexistent. The little amounts that existed were loaned to consumers and firms by banks. Coincidentally after each bout of QE, excess reserves skyrocketed with increases by $1 trillion, $0.6 trillion, and $1.2 trillion following QE 1, 2, and 3.
When used in conjunction with QE, IOR artificially sustained the federal funds rate above zero. It does this by preventing some amount of reserves from being loaned out, which is the equivalent of hoarding cash under a mattress instead of putting it in a bank where it can be loaned out. Contrastingly, if the Fed were to decide to set the IOR rate below zero, some amount of previously contained reserves would flow into the economy, and federal funds rate would decline. The Mises article also pointed out that after QE3 ended in 2014, when excess reserves began declining, the Fed increased the IOR rate from 0.25% to 1.5%. If that increase sounds familiar, it’s nearly the same increase federal funds rate underwent since then.
The Fed is raising the IOR rate to keep up with economic growth. As the economy grows, banks are incentivized to make more loans. These loans can only come from demand deposits which the excess reserves are converted into. Raising IOR slows the flow of excess reserves into the economy. If the Fed fails to do so, assuming an M1 (money supply used as the medium of exchange) of 1, banks would convert excess reserves of $2.6 trillion. That amount represents a 72% increase in M1 from its current stock of $3.6 trillion. Under the Quantity Theory of Money, consumer prices could accelerate at a startling pace of 72%. With the recent tax cuts and increased spending plans spurring economic growth, bankers will need to lend reserves to consumers and firms.
If the Fed wants to prevent the stimulus spillover into consumer prices, it will need to raise the IOR to slow the conversion of excess reserves into demand deposits. The problem is, raising rates would lead to an inverted yield curve, in which long-term bonds would yield lower than short-term bonds. This could trigger a recession.
What is the Fed’s next move? According to a chart for the TMS (total money supply), the money supply is shrinking. In response to the increased IOR and federal funds rate and the Fed’s decision to unwind its balance sheet, year over year (YOY) growth has dwindled from 11.15% in October of 2016 to 3.1% in December of 2017. This means the Fed is choosing the latter, to raise IOR rates. Unfortunately, it seems that a tool which the Fed deemed valuable in the past will soon turn into a curse, much like Pandora’s Box.