Since the beginning of the Great Recession, government has printed massive amounts of new dollars through a procedure known as quantitative easing (QE). Debate has since raged surrounding its consequences. “Keynesian” economists support it, and have ceaselessly pushed for more. Other economists have warned that printing such quantities of money portends inflation. The failure thus far of the latter to materialize has been seized upon by Keynesians as evidence that inflation is an unsubstantiated concern. Yet the threat remains real.
Opining in The New York Times, columnist Paul Krugman boasts:
Four years ago Meltzer and I effectively had a debate about the effects of the rapidly expanding Fed balance sheet. He (and others) warned of inflation ahead; I (and others) said that we were in a liquidity trap, so that the Fed’s bond purchases would basically just sit there.
So here we are four years later, the huge expansion of the Fed’s balance sheet has not, in fact, led to inflation.
Accordingly, Krugman argues that anyone who believes inflation a serious risk is not only wrong, but irrational.
Would that it were so, but it is not.
In the short run it is true inflation has–so far, at least–been held in check. Economist Allan Meltzer informs us why:
America’s central bankers need not search far to find out why QE is not working; evidence is published regularly for anyone to see. During QE2 (from November 2010 to July 2011), the Fed added a total of $557.9 billion to reserves, and excess reserves grew by $546.5 billion. That means that banks circulated only 2% of QE2’s contribution, leaving the rest idle. Similarly, since QE3 was launched last September, total bank reserves have grown by $244.1 billion, and excess reserves by $239.4 billion – meaning that 99% of the funds remain idle.
Given that banks earn 0.25% in interest on their reserve accounts, but pay very low – indeed, near-zero – interest to their depositors, they might choose to leave the money idle, drawing risk-free interest, rather than circulate it through the economy. At current interest rates, banks lend to the government, large stable corporations, and commercial real-estate dealers; they do not extend credit to riskier borrowers, like start-up companies or first-time home buyers. While speculators and bankers profit from the decline in interest rates that accompanies the Fed’s asset purchases, the intended monetary and credit stimulus is absent.
Put simply, that inflation has not arrived does not betray its threat: The excess liquidity has not been pumped into the economy. Once the economy establishes firm footing, however, if trillions of dollars of reserves are injected into the economy too quickly, that threat becomes a reality.
That is why economics extends beyond the concerns of the short run to the medium and long run. Inflation is not guaranteed, but suggesting it is a potential hazard to be taken seriously considers both the medium- and long-run consequences of policies now, and the Federal Reserve’s (Fed) ability to properly unwind those reserves without throwing a bucket of cold water on economic activity.
Economist JD Foster notes that the Fed has the tools to mitigate this potential disaster before it happens, but whether it has the wisdom to do so is another question.
All of this paints a sobering picture, according to Meltzer:
While subdued liquidity and credit growth are delaying the inflationary impact of the Fed’s determination to expand banks’ already-massive reserves, America cannot escape inflation forever. The reserves that the Fed – and almost all other major central banks – are building will eventually be used.
In sum, the U.S. economy has so far averted inflation. Still, it remains a legitimate risk. Until the Fed’s balance sheet successfully reverts to normal levels, it will persist as one.