It’s all about the money

Inflation has attracted little more than apathy from America’s political and economic leaders. Despite 21 months of inflation, measured by the consumer price index, surging from 0.4 percent in April 2020 to 7.5 percent, its fastest pace in 40 years, the media have focused on increases in various individual prices, not the pace of depreciation in the value of money. Policymakers, who initially argued the surge was temporary, only recently have begun to plan to act. 

Over the past four months or so, the Federal Reserve (Fed) has expressed a need to do something, but largely postponed action until next month. Congress and President BidenJoe BidenUS tells UN Russia has list of Ukrainians ‘to be killed or sent to camps:’ report Latest satellite images show shift in Russian military activity near Ukraine Biden agrees to meet with Putin ‘in principle’ if Russia does not invade Ukraine MORE seem unconcerned. They dither about the decision to confirm three nominees to the Fed’s Board of Governors, giving Americans little or nothing about their views on monetary policy. Two of the three nominees appear to focus on energy policy or income redistribution and have no record on monetary policy.   

A recent survey of 12 experts on how to address inflation provides more than 12 actions that could slow it. Most of these actions appear to be derived from popular suggestions about what caused the surge: COVID-19, supply chain problems, corporate concentration and excessive profit margins, problems obtaining child care, or former President TrumpDonald TrumpRepublicans scramble to halt Greitens in Missouri Mace: I’m going to win without Trump Walter Dellinger: a scholar and a mensch MORE’s trade war with China and others. There is no evidence that any of these factors raised the general level of prices over the past year, or earlier. No one mentions the unprecedented monetary expansion or reversing it. The extent of monetary expansion indicates that eliminating inflation will take several years. Adjusting expectations downward, suggested by one expert, can begin only when the Fed demonstrates that it will act aggressively. 

The Fed suggested in January that it cannot separate its interest rate and balance sheet targets when it indicated it will begin to raise the federal funds rate and end its rapid pace of balance sheet expansion in March. Higher interest rates reduce interest-sensitive spending, lowering the growth of monetary aggregates and of the Fed’s total assets. The president of the St. Louis Fed has indicated that a strong reaction is necessary to get the attention of financial markets and businesses — such as raising the federal funds rate by a full percentage point by July — suggesting to many observers support for a 50-basis-point rise in March and again in July.

This likely won’t be enough. A faster pace of slowing in the Fed’s total assets, including beginning with a large, one-time asset sale to withdraw much of its pandemic-related stimulus, is probably the next shoe to drop. The Fed should act more decisively — and quickly — to reduce the size of its balance sheet. The president of the Kansas City Fed recently went on record supporting such a step.

The Fed’s average total assets more than doubled from $4.1 trillion in the last week of 2019 (week ending Jan. 1,2020) to $8.8 trillion in the last week of 2021 (week ending Dec. 29, 2021). This extraordinary rise of $4.7 trillion in the size of the Fed’s balance sheet overstates the inflationary pressure created by the explosion in assets because much of the asset purchases did not flow through to a measure of Fed actions that influence money called the monetary base. The Fed’s measure of the monetary base rose by 87 percent, or $3 trillion, over the two-year period.

More than half of this rise, $1.7 trillion, came in the first five months of 2020, to fight the shortest and sharpest recession since the Great Depression. As usual, the Fed was slow to see the end of the recession in May 2020 and the strong expansion it had ignited. As in the past, the Fed allowed this unprecedented monetary expansion to continue for the next 19 months, fearing that the worst was not over. The emergency is long gone, however, at least based on broad measures of performance such as the unemployment rate or real GDP. The Fed should react appropriately and remove at least the first $2 trillion of that stimulus before most of its inflationary consequences appear. 

When past temporary emergencies occurred, the Fed often quickly reversed course. For example, in anticipation of the millennium time change, potentially creating shutdowns of the banking system and the economy, the Fed took actions at the end of 1999 to inject a relatively large amount of bank reserves and monetary base into the economy and quickly sold off assets in January 2000 when the century transition proved to be a non-event. The 9/11 terrorist attack led to the near shutdown of our payment system for a week or so, as flight suspensions grounded the ability to move checks and temporarily inflated checkable deposits. In that event, the Fed pumped massive reserves into the banking system to avoid banks’ reserves from becoming deficient and, within a week or so, removed those reserves as checks were cleared and excess deposits removed. 

A third instance occurred in 1980 when the Fed imposed credit controls and in response consumers and businesses reduced checkable deposits and built up currency holdings, sharply reducing monetary aggregates and causing, at the time, the sharpest and shortest (six-month) recession on record. When the credit control program abruptly ended in July 1980, currency holdings were redeposited in the banking system. Deposits and bank credit surged, causing an unusually large swell in the stock of money and real GDP in the second half of 1980.

It is not too late to pull the largest part of the expansion of the Fed’s balance sheet out quickly, before the lion’s share of its inflation effects materialize. A major reduction in the Fed’s balance sheet from March to May, selling off Agency mortgage-backed securities and Treasury securities, as well as allowing some of these assets to mature without replacement, could accomplish this. A one-time reduction in the balance sheet and monetary base of about $2 trillion would be comparable to the Fed’s purchases of assets and monetary base expansion over the comparable period in 2000.

This one-time securities sale could remove most of the excess liquidity in the economy without noticeable effects on economic activity. More importantly, it could result in a quick and major rollback in inflationary expectations before most of the consequences of injecting liquidity materialize. The Fed could reinforce this adjustment by putting the interest rate it pays on reserves back at zero, from the current 0.15 percent. This would reduce banks’ incentive to hold their excess reserves at the Fed and facilitate their ability to expand credit, including the purchase of the $2 trillion in securities the Fed currently holds. Despite the contraction in the Fed’s balance sheet, banks and other financial institutions could expand their lending and credit holdings by $2 trillion initially, and even more eventually.

These policy changes, along with action on the federal funds rate, would quickly dampen inflationary expectations without damaging output and employment. But they are only the first stage of the transition to price stability. Such actions could quickly cap the current inflation. Beginning at mid-year, the balance sheet would still have almost $1 trillion of excess liquidity that would have to be eliminated to remove the remaining inflation pressure from the money creation of the past two years. This is still large — over 20 percent of the projected monetary base at mid-year. A second stage of more normal policy restraint would be necessary to facilitate the return to price stability. 

Without such a one-time action, however, inflation likely will accelerate and continue at an unacceptable pace for years. 

John A. Tatom is a fellow at the Institute for Applied Economics, Global Health and the Study of Business Enterprise, Johns Hopkins University, and a former research official at the Federal Reserve Bank of St. Louis.