from Project Syndicate
Why Is US Inflation So Low?
28 June 2013
CAMBRIDGE – Why has quantitative easing coexisted with price stability in
the United States? Or, as I often hear, "Why has the Federal Reserve's
printing of so much money not caused higher inflation?"
Inflation has certainly been very low. During the past five years, the
consumer price index has increased at an annual rate of just 1.5%. The
Fed's preferred measure of inflation – the price index for personal
consumption expenditures, excluding food and energy – also rose at a rate
of just 1.5%.
By contrast, the Fed's purchases of long-term bonds during this period has
been unprecedentedly large. The Fed bought more than $2 trillion of
Treasury bonds and mortgage-backed securities, nearly ten times the annual
rate of bond purchases during the previous decade. In the last year alone,
the stock of bonds on the Fed's balance sheet has risen more than 20%.
The historical record shows that rapid monetary growth does fuel high
inflation. That was very clear during Germany's hyperinflation in the
1920's and Latin America's in the 1980's. But even more moderate shifts in
America's monetary growth rate have translated into corresponding shifts
in the rate of inflation. In the 1970's, US money supply grew at an
average annual rate of 9.6%, the highest rate in the previous
half-century; inflation averaged 7.4%, also a half-century high. In the
1990's, annual monetary growth averaged only 3.9%, and the average
inflation rate was just 2.9%.
That is why the absence of any inflationary response to the Fed's massive
bond purchases in the past five years seems so puzzling. But the puzzle
disappears when we recognize that quantitative easing is not the same
thing as "printing money" or, more accurately, increasing the stock of
money.
The stock of money that relates most closely to inflation consists
primarily of the deposits that businesses and households have at
commercial banks. Traditionally, greater amounts of Fed bond buying have
led to faster growth of this money stock. But a fundamental change in the
Fed's rules in 2008 broke the link between its bond buying and the
subsequent size of the money stock. As a result, the Fed has bought a
massive amount of bonds without causing the stock of money – and thus the
rate of inflation – to rise.
The link between bond purchases and the money stock depends on the role of
commercial banks' "excess reserves." When the Fed buys Treasury bonds or
other assets like mortgage-backed securities, it creates "reserves" for
the commercial banks, which the banks deposit at the Fed itself.
Commercial banks are required to hold reserves equal to a share of their
checkable deposits. Since reserves in excess of the required amount did
not earn any interest from the Fed before 2008, commercial banks had an
incentive to lend to households and businesses until the resulting growth
of deposits used up all of those excess reserves. Those increased deposits
at commercial banks were, by definition, an increase in the relevant stock
of money.
An increase in bank loans allows households and businesses to increase
their spending. That extra spending means a higher level of nominal GDP
(output at market prices). Some of the increase in nominal GDP takes the
form of higher real (inflation-adjusted) GDP, while the rest shows up as
inflation. That is how Fed bond purchases have historically increased the
stock of money – and the rate of inflation.
The link between Fed bond purchases and the subsequent growth of the money
stock changed after 2008, because the Fed began to pay interest on excess
reserves. The interest rate on these totally safe and liquid deposits
induced the banks to maintain excess reserves at the Fed instead of
lending and creating deposits to absorb the increased reserves, as they
would have done before 2008.
As a result, the volume of excess reserves held at the Fed increased
dramatically from less than $2 billion in 2008 to $1.8 trillion now. But
the new Fed policy of paying interest on excess reserves meant that this
increased availability of excess reserves did not lead after 2008 to much
faster deposit growth and a much larger stock of money.
The size of the broad money stock (known as M2) grew at an average rate of
just 6.2% a year from the end of 2008 to the end of 2012. While nominal
GDP generally rises over long periods of time at the same rate as the
money stock, with interest rates very low and declining, households and
institutions were willing to hold more money relative to total nominal GDP
after 2008. So, while M2 grew by more than 6%, nominal GDP grew by just
3.5% and the GDP price index rose by only 1.7%.
So it is not surprising that inflation has remained so moderate – indeed,
lower than in any decade since the end of World War II. And it is also not
surprising that quantitative easing has done so little to increase nominal
spending and real economic activity.
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