Federal Reserves Big Cash Injection

Image: Bryan Christie Design

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If you want to give yourself a jolt on one of these winter evenings, go to the Federal Reserve Bank of St. Louis’ website, and check out its chart showing what’s happened to the amount of money in the U.S. economy. What you will see is a flat line that turns, suddenly and sharply, upward.

The chart represents the total amount of money in the economy that the Federal Reserve directly controls—bills and coins as well as the reserves that the biggest banks keep at the Fed. In normal times, the monetary base grows at about the same rate as total spending. Between November 2007 and August 2008, as the economy expanded modestly, it increased from about $850 billion to about $875 billion. Then something remarkable happened. Between the middle of September and the end of last year, as the Fed pumped liquidity into the financial system following the bankruptcy of Leh­man Brothers, the monetary base shot up. When other liabilities are thrown in, the amount increased by $1.35 trillion.

Month by month, the acceleration has been stunning. Between August 27 and November 5, the monetary base rose at an annualized rate of almost 500 percent. Between October 8 and December 31, its annualized rate of increase was 922 percent.

The Fed has issued lots of money in previous times of stress, such as in the runup to Y2K, but never before on this scale. History tells us that if a central bank persists in creating money at triple-digit rates, inflation will skyrocket and the currency will lose much of its value. In the German hyperinflation of the 1920s, shoppers had to lug big bags of near-worthless marks to pick up their groceries. Zimbabwe provides a tragic contemporary example. As of November, the annual inflation rate in the ravaged African nation, according to one estimate, was 89,700,000,000,000,000,000,000 percent, which means that prices were doubling every five days.

Nobody is seriously comparing the United States to the Weimar Republic or Zimbabwe. But Ned Schmidt, publisher of the Value View Gold Report, called the Fed’s opening of the monetary spigots a “banana republic” policy, saying it could cause the dollar's value to fall 50 percent. Martin Hutchinson, a commentator at PrudentBear.com, said, “We should expect consumer prices to be increasing at an annual rate of more than 10 percent within 18 months of today.” Expressions of concern weren’t confined to goldbugs and stock market bears. “The Fed can’t just indefinitely create money without creating ­horrendous problems for the future,” William Poole, a former president of the Federal Reserve Bank of St. Louis and member of the Federal Open Market Committee, told Bloomberg Radio.

Some of the FOMC’s current members also appear to have misgivings. At the committee’s December meeting, they pushed for the establishment of official targets for the monetary base, which would limit Fed chairman Ben Bernanke’s freedom to issue greenbacks as he sees fit. The Fed announced it would consider the matter further, while at the same time confirming its intention to create a lot more money in the months ahead.

What is going on? Are we really headed for double-digit inflation and the end of the dollar’s role as the world’s reserve currency? I doubt it. There is much confusion about what the injection of funds means. When most people hear that the Fed is issuing large quantities of money, they imagine the printing presses cranking up, with sheets of new Andrew Jacksons and Benjamin Franklins rolling off the production line. Actually, the amount of currency in circulation hasn’t risen very much. On September 3, it was about $837 billion; by January 7, it had increased to $885 billion. In an economy where annual spending is about $14.5 trillion, an extra $48 billion in coins and bills is trivial.

Most of the dollars that the Fed has created during the past six months have stayed inside the financial system, where they are propping up such tottering institutions as Citigroup. The rest of the economy shows no sign of excess liquidity or incipient inflation. Current yields on Treasury Inflation Pro­tected Securities indicate that the market expects the inflation rate to be less than 1 percent 10 years from now.

The Fed has, so far at least, pulled off a very delicate trick. Under normal circumstances, the cash it has poured into the market would be inflationary. But with so much of the money being hoarded, that hasn’t happened. In fact, the risk is that the economy will starve from the lack of spending, causing deflation. The Fed’s challenge is to know when to respond, closing the spigots as soon as spending finally opens back up.

Bernanke is making up for past mistakes. With unemployment soaring and output falling, deflation—a general fall in prices—will most likely be a bigger threat to the economy than inflation, and it justifies the Fed taking some risks. Bernanke conceded to me last fall that he initially underestimated the economic threat posed by slumping real estate prices and a collapse in the market for subprime-mortgage securities. Since the start of 2008, however, he has acted aggressively, slashing interest rates and setting up a series of lending programs through which the Fed has allowed stricken financial firms to swap illiquid securities for dollars and Treasurys. He has been so aggressive because the banks have been so stingy with their money.

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