Salient to Investors:

Martin Feldstein at Harvard writes:

  • Historically rapid monetary growth fuels high inflation. Germany’s hyperinflation in the 1920s and Latin America’s in the 1980s.
  • More moderate shifts in US monetary growth rates fuel inflation. In the 1970s, money supply grew at an average annual rate of 9.6% and inflation averaged 7.4%. In the 1990s, monetary growth averaged only 3.9%, and inflation averaged 2.9%.
  • Quantitative easing is not the same thing as printing money which explains why we have not seen inflation.
  • The stock of money that relates most closely to inflation is primarily deposits that businesses and households have at commercial banks. Traditionally, increased Fed bond buying has led to faster growth of this money stock, but a fundamental change in the Fed’s rules in 2008 broke this link. As a result, the Fed has bought a massive amount of bonds without causing the stock of money, and thus inflation, to rise.
  • When the Fed buys Treasury bonds or mortgage-backed securities, it creates reserves for the commercial banks, which they deposit at the Fed. Commercial banks are required to hold reserves equal to a share of their checkable deposits. Before 2008, excess reserves earned no interest, giving commercial banks an incentive to lend to households and businesses. After 2008, the Fed began to pay interest on excess reserves which induced the banks to keep excess reserves at the Fed instead of lending.
  • The volume of excess reserves held at the Fed has increased from under $2 billion in 2008 to $1.8 trillion now, while the broad money stock, M2, grew at an average rate of just 1.5% a year. Not surprising that inflation has remained lower than in any decade since the end of World War II, and that QE has done little to increase nominal spending and real economic activity.
  • When bank lending resumes, high rates of long-term unemployment and underemployment may persist as inflation rises, thereby causing the Fed to decline from tightening and giving investors cause to worry that inflation could return.

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