Friday, July 23, 2010

The Fed's Balance Sheet: a Problem or an Opportunity?

(Click on figure to enlarge. Source: Cleveland Fed)

Is the Fed's expanded balance sheet a problem or an opportunity? It has grown from approximately $860  billion in early 2007 to about $2.3 trillion today.  That is an increase of over 250%. This enlargement of the Fed's balance sheet implies a corresponding increase in the monetary base.  Obviously, this large of an increase in the monetary base, if multiplied into increases in broader monetary aggregates like M1 or M2, has the potential to fuel spending and become highly inflationary.  But it hasn't happened as most of  the new monetary base is sitting in banks as excess reserves.  It is not being lent out and is far from living up to its reputation as  "high-powered money". Moreover, the market expects this to be the norm for years as inflation expectations across all horizons are falling.  The Fed's balance sheet, then, currently appears to be anything but a problem with regards to inflation.  Now someday it could be a problem, but right now it is not and that indicates the Fed is failing in its efforts to stabilize spending--the one thing the Fed can and should be doing.

Now since the Fed's balance sheet is not  currently a problem it actually has the potential to be useful.  In fact,  it presents a great opportunity to help change inflationary expectations and thus stabilize spending.  How so?  By publicly acknowledging  the inflationary potential of the Fed's expanded balance sheet.   Yes, this seems contrary to what I just wrote above, but that is exactly why it needs to be done.  If enough public officials and other influential observes express concern  about the Fed's balance sheet being inflationary and do it repeatedly then the public will become concerned too.  Inflationary expectations will then increase and  will thus lower current real interest rates, decrease the demand for money (i.e. increase velocity), and improve the outlook for the troubled household balance sheets (by increasing future asset values). 

Now inflationary expectations could overshoot using this approach and there are better ways to stabilize expectations like having the Fed explicitly commit to an inflation, price-level, or nominal GDP target.  But since the Fed seems reluctant to commit to an explicit target this seems like the next best approach.  So talk it up! Sound the alarm! Inflation is coming!


  1. Inflation IS coming. The profligate government spending of the past ten years,piled on top of what was already a huge national debt, has guaranteed that. It's just a matter of when, not if.

    According to what I read, there is only one historical example of a country ever growing its economy out of hole like the one we are in now. And the circumstances of that were considerably more favorable overall than what we face at present.

    Americans won't embrace true austerity or willingly give up their entitlements.

    Even the massive tax increases we are probably about to experience cannot provide enough revenue to get us there.

    So, we default on our debt or inflate it away. I'm guessing it will be the latter.

  2. Since the financial crisis is the result of a run and subsequent collapse of the shadow banking system. The fed needs to mimic the shadow banking system. They need to do QE by buying a broad spectrum of new issues of asset backed securities. We should not delude ourselves into thinking that this will stimulate the sluggish economy. But it will help stabilize things.

    The real issue is a lack of faith in the Obama administration on the part of the people who create jobs. The fed can goose NGDP but the fed can't put people to work. Nevertheless, stagflation is better than asset deflation.

    Relative prices are severely out of whack. The Whopper price of FL real estate is way, way too high. There are two ways to bring the economy back into balance. The dollar price of real estate can fall or the dollar price of Whoppers can rise. It seems to be better if the price of Whoppers goes up. The alternative is to put half the nation's homeowners underwater on their mortgages.

  3. I disagree with the view that "Inflation IS coming" expressed earlier.
    In my view (an Austrian one) there are three general ways to achieve inflation: growing the money supply (falling in US), a rise in the velocity of circulation (does not seem to happen at present) or a fall in the industrial output(not sure what happens in the US).
    My view is that while people believe that the USA is The Great One they will not likely raise the velocity of money. The economy is in a bad shape. That is why banks do not lend, because there are few creditworthy borrowers.
    The economy of USA will not likely come to life. It is damaged structurally and with a huge debt overhang which is still raising. So - more deflation, more quantitative easing, etc. At some time along this way the inflation will pick up with a possible hyperinflation. My guess: in the short term: deflation or weak inflation.
    The author is right for at least one thing: at present the FED's balance sheet is not a problem.

  4. Anonymous I to Anonymous II.

    In the short run, perhaps you are mostly correct, at least with respects to asset deflation. But if they can,the bankers ( i.e. the Fed) will stabilize asset prices, because it is in their best interest to do so. The QE they use to do this WILL lead to eventual inflation,and yes --- quite possibly -- hyperinflation. On that at least, we can agree. As I said, the "when" of this difficult to predict.

    But at the same time we have falling asset prices, we will continue to see the prices of many necessities go up, and with time, even the cheap consumer items we take for granted will be more expensive, as the China effect unwinds.

    Do you think, as home prices fall, that it will be cheaper for you to go to the dentist? Pay for college tuition? Buy gas for your car? Buy a six pack? I wouldn't look for that.

    In the real world, inflation and deflation are not mutually exclusive. They can occur simultaneously in different sectors.

  5. From Anonymous II
    When speaking of deflation I did not mean just asset deflation but the standard definition of deflation. At present in the USA (as I understand; I am from Eastern Europe) there is some inflation (and most likely it is more than the official figure if we check My guess is that there will be another leg down of the economy in the USA (and quite possibly abroad) and deflation will occur despite the attempts to relfate.

    You are absolutely right that money is not neutral, it will raise the prices where it flows and the rest may even fall.

    If the economy was OK the inflation should have gone up significantly. This is what was to be expected from a "stimulus". This is not the case however. I wonder to what extent the present inflation is due to the fall in the output of goods and services and/or some money leaking to comodities. The contraction of credit to companies and the general folks is real, so something must have over-compensated for this efect.

    (By the way if Peter Shiff is right, then home prices do not count towards the CPI measurement directly. Some kind of "imputed rent" or something like that is measured.)

    From some time I think that hyperinflation will not happen easily in a society where almost all of the money is credit. If banks are allowed to go under hyperinflation just can not happen. It will be possible only if the government keeps the banks open despite their being broke (as is the case now and most likely in the future). I have been through a "paper" hyperinflation and it was very - very bad by the way.
    In general the Austrians speak and always tend towards inflation (and historically they are right) but I think that at present they underestimate the deflationary potential ahead.
    In general Keynes's ideas work only with a relatively healthy economy. This seems not to be the case in US and the additional capital consumption by the money creation will in my opinion just make things worse.

    I have been trying to guess the future but it is hard to do so. Especially when it comes to Europe.