Why Is Inflation Low?

Although there isn’t consensus about the effects of expansionary monetary policy on the economy; with some arguing money creation would just lead to higher prices and others believing it is a powerful tool to create growth; there’s no doubt the real effects lie somewhere in the middle. Money creation can certainly give a boost on national output and help manage liquidity problems but when abused it will generate inflation.

During the gold standard, in the period between 1873 and 1971, the average inflation rate was about 1.36%. With the extinction of the Bretton Woods Agreement in 1971, inflation picked up and averaged 4.36% between 1972 and 2012. Full convertibility between gold and the US dollar prevented the US government from the temptation of printing money to pay the extra bills. Any attempt at letting the monetary base grow more than GDP, would quickly lead to queues of people exchanging their dollars for gold and thus ultimately contract the monetary base again. During periods of war, between 1861 ? 1865 (Civil War) and 1914 ? 1920 World War I), the US government put the gold standard on hold, abandoning it temporarily, to pay for the extra war costs through money creation. The result was hyperinflation. An accelerated money creation has often leaded to two-digit inflation rates.

With all this in mind, we should ask ourselves why is inflation contained below 2% with the FED running a balance sheet stretched to the trillions. After three quantitative easing programs and with interest rates at record lows, why is inflation standing pat?

When the FED prints money, it is basically expanding M0 or base money as it is often named. The FED buys Treasuries, MBS, or any other assets and the money will flow to commercial banks. During the last few years, the FED expanded M0 from $800 billion to the current $3.2 trillion, quadrupling it. Commercial banks complete the job by lending to clients. As they are required to keep just a fraction of what they lend as reserves, there is a multiplying effect.

M2 may be used as a rough measure for the money supply. By dividing M2 by M0 we find the money multiplier, which has traditionally been around 10x for the US economy and stable over decades.

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With inflation under 2% per year as if we were under the gold standard, there must be some missing link. Is the FED using some special tool allowing for massive money printing while keeping inflation low?

In fact they’re not magicians and the real explanation lies on a massive failure in the monetary policy mechanisms. Banks aren’t creating money, at least at the desired pace. They’re just depositing their excess reserves back at the central bank instead of lending to clients. The following chart shows the evolution of the money multiplier, which helps understand what’s happening.

As you can see, there’s a huge decline occurring in 2008, which corresponds to legislation approved regarding the remuneration of excess reserves held at the FED by commercial banks. Until October 2008, excess reserves weren’t earning any interest and thus banks had to find better places to use their money. But with the new legislation banks now prefer to keep their excess reserves at the central bank instead of lending to households and businesses. As a result, from just a little more than $1 billion in August 2008, excess reserves grew to more than $1.8 trillion today. The money multiplier dropped from 8.8x to 3.3x during the same period.

We now clarified why inflation isn’t picking up in the country. It’s not magic but rather a missing link inside the money creation mechanism. And this is worrying because if interest rates rise, banks will withdraw their money from the central bank and find better uses for it. If $1.8 trillion suddenly enters the market, the $85 billion per month the FED currently injects in the economy will look like the alms you give to the street beggars!

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