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Source link: http://archive.mises.org/9829/federal-reserve-monetary-expansion-threatens-future-rising-prices/

Federal Reserve Monetary Expansion Threatens Future Rising Prices

April 22, 2009 by

Over the last nine months Federal Reserve monetary policy has been working over time with a huge expansion of the money supply, especially in the monetary base, that is setting up the U.S. economy for significant price inflation in the not too distant future.

I discuss the Fed’s activist monetary policy in terms of a various monetary aggregates in a new piece of mine on, “Federal Reserve Monetary Expansion Threatens Future Price Inflation.”

The monetary base grew by 90 percent between August of 2008 and early April 2009. Two other monetary measures, M-1 and M-2, respectively, went up 18 percent and 10 percent during this period.

Why hasn’t the large growth in the monetary base been reflected in higher rates of growth in M-1 and M-2? Because a large proportion is being held by banks as excess reserves, i.e., reserves in excess of required reserves on outstanding depositor liabilities.

In August 2008, excess reserves equaled 4.4 percent of total bank reserves. In early April 2009, according to the latest Fed report, excess reserves stand at 93 percent of total reserves.

Banks have been shoring up their cash position in the wake of the financial crisis that broke out last year. Also, the continuing uncertainties about the economy, and especially government regulatory, fiscal and monetary policy, have made many banks reluctant to get themselves out on a limp again. And, in addition, the Federal Reserve has been paying a positive rate of interest on excess reserves held by the banks.

But when those excess reserves starting being lent out, either to private sector borrowers or to the Federal government to fund its massive budget deficits this year and next, those hundreds of billions of dollars created by the Fed will start putting upward pressure on the prices for investment goods, labor, resources, and consumer goods.

The lingering fears expressed in the media about price deflation will turn into the reality of rising price inflation.

Richard Ebeling


Kyle April 22, 2009 at 11:22 am
Steven April 22, 2009 at 12:16 pm

I recently read this article –


- which states that inflation is not a concern because of the Fed’s ability to manipulate the reserve rate and that this is precisely how Bernanke and Co plan to keep it under control. I am certainly not an economist but I immediately spotted several things in the article that seemed to indicate that their conclusions are unfounded. I would love to read the thoughts of some better-trained minds.

Mechanized April 22, 2009 at 12:27 pm

Kyle (commenting on the link you provided):

Those who believe, just as the individual who stated, incredibly, that the market has been self regulating [during the past decade] has placed too much faith in television pundits.

Even a mere glance at The 2008 SEC Guidelines; Rules and Regulations, 4116 pages of regulations upon the financial industry, should make it quite obvious that the market was anything but self-regulating during this period. In fact, market self-regulation has not occurred for well over a century.

dewind April 22, 2009 at 12:58 pm

The link that Kyle provided asserts that credit money M1 and M2 ‘forces’ the federal reserve to monetize credit via M0. Essentially, banks provide loans to which they do not have reserves for yet. The Federal Reserve later monetizes it. If the reserve bank chooses not to monetize it we than have a credit crunch.

The conclusion being that our current economic system is that of ‘credit’ and not ‘fiat’. The banks are the cause of the failure and not the Federal Reserve because they drive the forces of credit.

If I understand the article, the argument appears to be flawed. The Federal Reserve sets the interest to which banks decide how to lend based on this primate rate. Additionally, the banks lend unabashed because we have a ‘lender of last resort’ that gladly monetizes any credit that is created.

If a bank did not have the option to leverage the Federal Reserve they would have 2 options.

1. Go bankrupt
2. Lend conservatively

FGF April 22, 2009 at 1:18 pm

Kyle – from Frank Shostak (11/27/2007)

“Contrary to Minsky and the other post-Keynesians, it is the existence of the central bank that makes the present capitalistic framework unstable and susceptible to financial turmoil. It is not the expansion of credit as such that leads to an economic bust but the expansion of credit ‘out of thin air’…”

Nathan April 22, 2009 at 1:35 pm

Kyle’s link seems to conclude what Libertarians have always said: Neither government or business is especially bad or good, but in combination they are the ultimate coercive tools. Banks expanding credit on the notion that they can incentivize the FED into printing money makes perfect sense in this framework. The FED after all is controlled by the banks and the Presidential appointment is little more than a puppet charged with the goal of solving the credit problem.

Kyle April 22, 2009 at 2:02 pm

To all who have replied,
Yes yes, I agree with all of you. The central bank is a huge problem, IMO mostly because it allows the financial system to get away with creating unsustainable amounts of credit. I don’t have a chart handy, but I urge you to take a look at historical levels of total dollar-debt as a percent of nominal GDP. In the post-war period, before leaving the gold standard for good in 1973, debt/GDP hovered around 125-150%. In the years that followed, this number began accelerating, slowing somewhat after the S&L crisis, and will undoubtedly slow again around it’s current level of about 450%. The Fed can continue propping up this debt expansion to keep prices from deflating, but this cannot continue forever.

My point in linking Steve Keen’s article was to demonstrate that Richard really oversimplified the rationale supporting his inflation conclusion. The Fed’s actions thus far have been unprecedented but are small in comparison to 1.) the private banking system’s total outstanding debt levels, and 2.) the amount of stimulus/QE that may actually be needed to support such an insolvent financial system in the next couple years. If the Fed is willing to go all the way and replace all the bad debt with actual currency, we will probably see hyperinflation as soon as the business cycle ramps up again.

Lucas M. Engelhardt April 22, 2009 at 2:03 pm

One important empirical point re: the article Kyle links to:

Rejecting the money multiplier based on debt-to-money ratios depends on properly measuring debt and money.

I suspect that the “debt” measure Keen uses includes things like corporate bonds – which do not create money, and would therefore allow the debt-to-money ratio to become infinity, even if the money multiplier story is true.

Also, dewind is right – without the government’s guarantees (including those of the FDIC and Fed), banks wouldn’t be nearly so willing to lend so much money.

Kyle April 22, 2009 at 2:06 pm

Oh, an edit, because I don’t think I was clear:

by “allows the financial system to get away with creating unsustainable amounts of credit,” I meant that the CB doesn’t allow the market to cleanse itself as it would in a world with totally private currency. Too much debt should cause the failure of institutions that made lending errors/miscalculations, but instead it just causes the CB to juice the economy. This results in ever-increasing amounts of debt.

Kyle April 22, 2009 at 2:30 pm

Thank you for making an interesting point. I had to think about this for a minute but I believe you’re not entirely right about debt such as corporate bonds. Please correct me if this argument doesn’t make sense.

Most buyers of debt instruments such as corporate bonds are institutions such as pension funds, insurance companies, etc. Like banks, these entities have obligations to people whom they owe money; in the case of pension funds, employees who will someday retire and receive their pensions. In essence, they are receiving deposits (directly from the employer, indirectly from the employee’s wages) and using those deposits to invest.

Pension A has $100 in deposits from its firm’s employees. It invests the $100 in an IBM bond, and IBM buys a new piece of machinery for $100 from Manufacturing Co. Manufacturing Co. takes the $100 and deposits $50 into their pension fund and $50 into their bank. Their bank loans out the $50 to IBM through a new revolving credit line, and Manufacturing Co.’s pension fund loans $50 to IBM in exchange for IBM bonds… etc.

What did I miss?

fundamentalist April 22, 2009 at 2:31 pm

Although the monetary theory from your link comes from neo-Keynesian econ, it is very similar to the Austrian theory of money that the author of this article, Richard Ebeling, espouses. Mr. Ebeling doesn’t provide the entire Austrian theory of money, just the aspect of it that relates to increases in base money. While most credit expansion does take place as the neo-Keynesians describe, it can happen the other way, too. The whole purpose of increasing the monetary base is to persuade banks to make more loans. And eventually they will, when businesses decide they’re ready to borrow again. For the Austrian explanation of credit money check out Hayek’s “Monetary Theory and the Trade Cycle” and Huerta de Soto’s book on money and banking, both of which are very similar to Steve Keen’s presentation.

Hayek said that the worst thing economists could do is to ignore the quantity theory of money. The second worst would be to take it too literally. Milton Friedman and the neo-classical guys take it too literally and that’s why they can’t predict anything.

Dick Fox April 22, 2009 at 2:50 pm

…the Federal Reserve has been paying a positive rate of interest on excess reserves held by the banks

This is what has caused the huge reserve increase. The banks can make money risk free by parking cash in their reserves.

In typical demand side style the FED is trying to stimulate the economy by increasing the money supply, but the banks don’t want to borrow even at a zero rate of interest.

The FED was out of conventional arrows with a zero interest rate, and so as amazing as it seems they have moved to negative interest rates. Paying interest on reserves is the incentive for banks to borrow from the FED. They can take the borrowed money at a zero rate of interest and park it in their reserves and receive a positive risk free rate of interest. The FED is paying banks to take their money, negative interest rates, and it is an intentional move by Bernanke. He admitted such when he lowered interest rates to zero.

But ironically this very creative technique has hit the FED with unintended consequences. All of the money that was supposed to stimulate the economy is not even in the economy. It is in reserves drawing interest.

The FED has actually painted itself into a corner. If it stops paying reserves the banks will stop taking FED money ending their “stimulus,” but paying interest on reserves serves as a dam holding back the excess cash from entering the economy.

At some point the FED will have to break the dam and all hell is going to break lose. It is highly likely inflation will soar. Bernanke thinks he has the tools to soak up the excess before it causes a problem, but with the economy in decline the political pressures on him to “not create deflation” will be huge, probably more that he can possibly handle because it could cost him his job.

The FED has created its own nightmare but we will be the ones to suffer. Bad economic theory leads to horrific wealth destruction and politics just amplifies it.

debtus April 22, 2009 at 3:18 pm



The initial deposit of $100 into the pension fund came from someone’s bank account (the employees) and ultimately ends as $100 in another person’s bank account. In this case, there is no money creation.

However, if a bank loans IBM $100 because it has excess reserves or if the Fed prints $100 and monetizes IBM’s bond, then money supply has increased.


Banks can only borrow from the Fed at 0.5% (Discount rate). The rate the Fed pays on reserves in 0.25%, so banks cannot profitably borrow from and lend to the Fed.

FGF April 22, 2009 at 4:15 pm

debtus -

“Banks can only borrow from the Fed at 0.5% (Discount rate). The rate the Fed pays on reserves in 0.25%, so banks cannot profitably borrow from and lend to the Fed.”

According to the most recent H3, about $596 BN of the banks’ current $862 BN total reserves are ‘borrowed’ versus $57 BN ‘required’. Are they voluntarily incurring negative carry on this amount?

Kyle April 22, 2009 at 4:56 pm

Debtus, follow my example again and you will notice the creation of $100 of credit-money. Or maybe I can simplify it further:

Pension fund loans IBM $100 for a machine. IBM buys machine from manufacturer. Manufacturer puts the $100 into their pension fund, who then loans the money to IBM for a second machine. IBM buys machine. IBM has bought two $100 machines with initial deposits of $100. Repeat ad nauseum. This is the same as the bank credit multiplication proces: it puts upward price pressure (aka. price inflation) on the machine market.

debtus April 22, 2009 at 5:05 pm

Well, define ‘voluntarily.’

The banking system is insolvent. Insolvency is normally followed by illiquidity; the two work hand in hand.

In this case, the Fed is providing ‘liquidity’ to the insolvent banking system. If the banks did not borrow reserves, they would face the likely possibility that they would be unable to redeem deposits, pay back debts, etc. They would be unable to operate.

So yes, it’s the banks’ choice to borrow at negative interest rates, but only because they would implode if they did not.

Jason White April 22, 2009 at 6:12 pm

Kyle, The problem with your example is that the manufacturer of the machine cannot possibly continue to put $100 into their pension fund and or bank account. The cost to manufacture the machine is non-zero. Based on usual margins, their cost is probably $80 or so.

g April 22, 2009 at 6:24 pm


pardon me, but doesn’t your example show the creation of 2 machines but no new money?

Fred April 22, 2009 at 8:16 pm

Did I get this right? Did the Vox article suggest that the fed could pay interest to the banks on their excess reserves, which they obtained by trading their toxic (legacy) assets for Treasuries or cash, to encourage the banks not to lend, and thereby keep the excess reserves from causing excessive inflation. Sounds like a sweet, risk free deal. Brilliant business plan – a risk free arbritrage. Lend to anyone, trade the waste for an asset secured by the Fed and then collect interest.

Kyle April 22, 2009 at 8:32 pm

Yes, my example was a bit of a simplification, but the argument still holds. Use your example of $20 profit and you’ll see the same effects, with a little bit of extra lag. The $20 profit is deposited in the company’s pension fund or bank, which then gets loaned out to another company. The $80 in cost is paid to suppliers, who deposit their profits in the bank (who then loans it out) and pay out some to their suppliers, and on and on. This is the same way the multiplication works with traditional bank lending: bank receives deposit, bank loans deposit to company, company pays vendors for their projects, vendors deposit money, banks loan money…. and the same logic applies to corporate bond lenders.

Think of it this way. You have a wallet with $100 in it. It’s a magic wallet, and every time you spend the $100 it regenerates the cash out of thin air. So each time you go to make a purchase, you only have $100, but you can make several $100 purchases. Is there still only $100?

The key to the scenario I described is that in purchasing those two machines, the manufacturer has received *two* sets of $100. Not two IOUs for $100, but two actual sets of $100. It *feels* like there is actually $200 in the system as a result, and prices will reflect that, which is why price deflation happens when credit crunches, and why the Fed is freaking out about this in the first place.

If you kind of get it but want to hear more, have a look at this work-in-progress paper of mine: “Phantom Money: The macroeconomic role of dollar-debt in the financial crisis.”


If you have any suggestions or get confused, I’d love your feedback! kjn7@case.edu

George April 22, 2009 at 8:37 pm

The fed isn’t the problem.

Can someone explain to me how, if Congress really wanted to they couldn’t remove or change anything about the Fed that they wanted to remove or change?

A guess at what’s in the future — that money the banks are holding will go into US treasury debt — there’s a whole lot due to be issued…

Félix April 23, 2009 at 3:17 am

I have been saying exactly this for a while, the moment banks start to put reserves to work… we are going to see a money supply explosion.

Congressional oversight Panel already admitted that bailouts, FDIC, TARP, TALF, etc total over $4Trillion… imagine what will happen when the money multiplier gets to work on that base!
Even if a lot of dollar value has been lost in the liquidation black hole… (IMF says $4Trillion worldwide), there is no way we can avoid hyperinflation now….

Steven April 23, 2009 at 4:09 am

Fred, that was my take on the Vox article as well. It also seemed to imply that the Fed could use the reserve rate to keep all that money from flowing into the economy, or at least to control the flow, by keeping that rate higher (or high enough) that the banks would rather make the risk-free rate than lend the money. So, the Fed would be competing with borrowers once the interest rate reached a certain point? Sooner or later that “money” has to go somewhere doesn’t it? Either it starts to get into the economy or the Fed is paying higher and higher interest payments in an effort to stop it. I feel that I’m missing some essential point…

newson April 23, 2009 at 5:12 am

to kyle:
your example shows no money creation, only credit creation (even with a pure specie monetary order, credit would ebb and flow subject to individuals’ choices). how does ibm get the second loan? the fact that the manufacturer deposits its receipts with the same pension company is neither here nor there. if ibm gets the second loan it’s because the pension fund is economizing to accommodate them on their own merits.

credit is merely the temporary ownership of a given amount of money, title to which reverts on loan extinguishment, no money creation involved.

banks are able to loan money without any corresponding economizing by somebody else (up to their reserve limit).

that steve keen doesn’t agree with the neoclassical school isn’t enough to make him right.

newson April 23, 2009 at 5:32 am

base metals seem to be sensing reflation. in the last six months or so, copper is up 54%, lead 62%, palladium 50%.

Lucas M. Engelhardt April 23, 2009 at 7:06 am


Here’s the problem:

Pension funds aren’t in M1, M2, or M3. So, they won’t be included in Keen’s measure of “money”. (Whether they should be included is a different argument.) So, what happens in your pension fund example?

The pension fund has some cash holdings (these are in M2 probably). They loan the money to a manufacturer. At that point, the cash holdings of the pension fund decline by the same amount that the manufacturers cash holdings increase. So, we have $100 of new debt, but $0 of new money (as measured by M1, M2, or M3). Of course, the borrower can buy something (leading to another pure transfer of money), the seller of the thing can put the money in their pension fund (no change in money supply there), and the pension fund can loan it again – creating more debt, but still no more money (at least as measured by M1, M2, and M3).

Now, if you want to argue that pension fund balances should count as money, that’s another argument. My point is just that they aren’t counted as money in the aggregates Keen chose, which means that his debt-to-money ratios will fail to provide any evidence against the money multiplier story, as the concepts underlying his debt and money statistics don’t line up with the money multiplier story.

2nd Amendment April 23, 2009 at 8:51 am


Business is good, government is bad.

Government business is the ultimate evil incarnation !

FGF April 23, 2009 at 9:28 am

I know there is a lot of debate about if and/or when reserve creation will dominate the private sector deleveraging. If the banks’ holding of excess reserves is a matter of survival, e.g. maintaining liquidity, they’ll be reluctant to ‘loan up’ to the extent allowed within their current reserve requirements. However, the question I have is to what extent inflation will occur if the banks invest their reserves in higher yielding, but still liquid, Treasury offerings.

redshirt April 23, 2009 at 11:13 am

My understanding of the inflationary risk is that the real risk is in the overseas flow of money back to the US. There is no particular reason other countries (especially in Asia) won’t start utilizing another currency in place of the dollar (say in a year or so). The Asian countries are under served in themselves so have plenty of economic growth to be had just in improving their standard of living (Peter Schiff’s notion). The dollar will find fewer and fewer homes sending more and more of them back here. We’ll be flooded. (But we’ll be able to export a lot of stuff!)

It could happen very quickly.

I’m not so sure about fractional lending… the big banks are deep in the hole and the smaller more conservative banks should have more sense.

FGF April 23, 2009 at 12:49 pm

Inflation, i.e., an increase in ‘true’ money supply (currency in circulation and demand deposits) is strictly a matter of reserve creation and fractional lending. The Fed ‘printed’ money, some of which went offshore to pay for imports. The recipients thereof had several choices: 1) buy trade goods from us, 2) sell dollars for local currency or 3) buy Treasury debt as reserves to inflate their own money supply. Per Schiff, most of our biggest trade partners went the third route, so obstensibly these dollars are already here.

LT April 24, 2009 at 1:54 am

Kyle, don’t forget that IBM will eventually have to pay up all that dough plus interest. As long as the pension fund is investing for future payouts and not treating it like a bank account, where you can take out as much as you want, anytime you want.

FGF, so what happens when they want out of treasuries? Who’s going to buy treasuries then? The Fed? … They’ll have little choice but to monetize the debt.

Brian Macker April 26, 2009 at 10:42 pm


Steve Keen doesn’t understand Austrian economic theory and confuses it with other theories. Kinda sad for an economic professor.

He makes all the mistakes pointed out by the commenters here and more.

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