First consider the monetary effects. When the Fed purchases public or private securities or makes loans to banks or to other private firms, it must finance them. The Fed can borrow the funds, or it can ask the Treasury to borrow the funds, or it can do it the old-fashioned way: create money. The Fed creates money in part by printing it but mostly by crediting banks with deposits at the Fed. Those deposits are called reserve balances and are the key component – along with currency – of base money or central bank money which ultimately brings about changes in broader money supply measures.
These deposits or reserves have been exploding as the Fed has made loans and purchased securities. Six months ago reserves were $8bn, in a range appropriate for its interest rate target at the time. As of last week, reserves were nearly 100 times larger at $778bn, the result of creating money to finance loans to banks, investment banks, AIG, central banks and purchases of private securities. Before last week’s federal open market committee meeting, I projected these would increase to $2,215bn by the end of this year if the new Consumer and Business Loan Initiative of the Treasury were to be financed by money creation. With last week’s dramatic announcement, the Fed will have to increase reserves by another $1,150bn to $3,365bn by the end of the year if the securities purchases are financed by money creation. Quantitative easing or credit easing means that the growth rate of the quantity of money increases, but there is no monetary principle or empirical evidence supporting such an explosion.
There is no question that this enormous increase from $8bn to $3,365bn will lead to higher inflation unless it is reversed. With the economy in a very weak state and commodity prices falling, inflation does not appear to be a problem now. The growth of reserves has led to an increase in the growth rate of the broader money aggregates, but less than proportionately because banks are still holding excess reserves. The Fed has expressed its concern about inflation with its new target-like longer term forecasts for inflation and by saying it will remove the reserves in due time. However, increases in money growth affect inflation with a long and variable lag. Will the Fed be able to change course in time? To do so, it will have to undertake the politically difficult task of getting more than $3,000bn of government securities, private securities and loans off its balance sheet. Making it more difficult are the extraordinary borrowing demands by the Treasury and the announcement of Treasury purchases by the Fed.
To avoid inflation all the Federal Reserve, and government will need to do, understand these are the same folks, regardless of party who couldn't see this downturn happening, all they will need to do is remove three trillion worth of dollars from the economy at the appropriate time and rate. They will need to do this, as noted above, even when the government wants to continue to borrow and demand the creation of money to help make this happen.
Of course it is entire possible that all of this could happen. However the reality is that for more than a generation, for several generations the government has been debasing the currency and then borrowing on top of that fact. The Federal Reserve and various elected officials have failed to stop ever increasing bubbles springing forth from the mid 80's until now. It is akin to saying you can stop your heart disease, all you need to do is lose 100 lbs. and win the N.Y. City Marathon. It might be possible but it isn't very probable.
Finally our current president really talks a great game about responsibility and moving from a ponzi economy but in actuality makes a big down payment toward growing government, reelecting party officials and keeping the downturn pain-free for as many people as possible. So apparently the initial stage of training for that marathon is to grab a big remote and order up $800 billion in pork ribs.
It isn't looking good.
