Will The Fed Be Able To Contain Inflation After All This Stimulus?

There’s constant debate about whether inflation will become too much to bear in the wake of massive Fed stimulus. We’ve generally supported the argument that inflation will become an issue, but also said that the Fed has tools to control it if they have the political will. This weekend, Harvard Economics professor Gregory Mankiw wrote a piece for NYT and does the best job we’ve seen lately exploring why bond markets don’t appear too worried about inflation—and it does address the tools the Fed has at its disposal. Key excerpts below, and full article here:

Part of the answer [as to why bonds don’t seem too concerned about inflation] is that while we have large budget deficits and rapid money growth, one isn’t causing the other. Ben S. Bernanke, the Fed chairman, has been printing money not to finance President Obama’s spending but to rescue the financial system and prop up a weak economy.

Moreover, banks have been happy to hold much of that new money as excess reserves. In normal times when the Fed expands the monetary base, banks lend that money, and other money-supply measures grow in parallel. But these are not normal times. With banks content holding idle cash, the broad measure called M2 (including currency and deposits in checking and savings accounts) has grown in the last two years at an annual rate of only 6 percent.

As the economy recovers, banks may start lending out some of their hoards of reserves. That could lead to faster growth in broader money-supply measures and, eventually, to substantial inflation. But the Fed has the tools it needs to prevent that outcome.

For one, it can sell the large portfolio of mortgage-backed securities and other assets it has accumulated over the last couple of years. When the private purchasers of those assets paid up, they would drain reserves from the banking system.

And as a result of legislative changes in October 2008, the Fed has a new tool: it can pay interest on reserves. With short-term interest rates currently near zero, this tool has been largely irrelevant. But as the economy recovers and interest rates rise, the Fed can increase the interest rate it pays banks to hold reserves as well. Higher interest on reserves would discourage bank lending and prevent the huge expansion in the monetary base from becoming inflationary.