It must be impossible for the Fed to create inflation

By Warren Mosler

Hardly an hour goes by without some pundit pushing the possibility of some kind of run away inflation, with Zimbabwe and Weimar rolling off the tongues of ordinary Americans everywhere. And Congressman and candidates of all persuasions continuously lambaste the Fed for debasing the currency.

There’s no question the Fed has been trying to reflate, particularly with regard to housing. They were not going to make the mistake Japan made, so they rapidly dropped the fed funds rate to near 0%, provided unlimited bank liquidity, and then went on to buy $trillions of US government securities in an attempt to support demand and prices by adding more liquidity and further bringing down long term interest rates and mortgages. The stated and obvious intent has been to do everything they can to support a private sector credit expansion that would support prices and the aggregate demand needed to reduce unemployment.

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For all practical purposes the Fed has done it all. And yet unemployment remains at depression levels of over 9% (and over 16% the way it used to be calculated not long ago) and the only thing keeping what’s called ‘inflation’ over 1% is a foreign monopolist supporting the price of crude oil.

So if inflation is this ominously lurking around every corner that requires eternal vigilance to keep from suddenly rearing it’s ugly head, why have all the Fed’s horses and all the Fed’s men not been able to inflate again? And why would anyone still think they can? I mean, we’re talking about college graduates with advance degrees and resources and power up the gazoo doing everything they can to reflate, and still failing after 3 long years? Not to mention the same in Japan for going on 20 years, where they have college grads with advanced degrees as well (though pretty much from the same schools).

Maybe this inflation thing is harder to get going than it looks? And what did go on in the German Weimar Republic, where if you parked a wheelbarrow full of money thieves would take the wheelbarrow and leave the money? Turns out it was those pesky war reparations that caused government deficit spending to soar to something like 50% of GDP annually, with most of that whopping deficit spending used to sell the German currency and buy foreign currency to pay their war reparations. As expected, that drove their currency down the rat hole in short order, and kept driving it down, causing that famous bout of hyper inflation that didn’t end until that policy ended. And when all that ended and policy changed the inflation stopped dead in its tracks. In one day. So how about Zimbabwe? Turns out they had a tad of civil unrest that dropped their productive capacity by about 80%, but government spending stayed high and too much spending power with too few goods and services for sale drove prices through the roof. Not to mention rumors of insiders using the local currency to buy foreign currencies for personal gain (sound familiar).

Applying this to the US to replicate the Weimar inflation Congress would have to increase the deficit to about $8 trillion a year and then sell those dollars continuously in the market place, using them to buy the likes of yen, euro, and pounds. And replicating Zimbabwe would mean some kind of disaster that wiped out 80% of our real productive capacity and then continuing to spend federal dollars as if that never happened.

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But note that it turns out these examples of hyper inflation are traced back to wildly excessive govt. deficit spending, and not actions by the Central Banks. And, in fact, from what I’ve seen those kinds of levels of deficit spending always cause inflation, no matter what the Central Bank does. For example, deficit spending and indexation of prices paid by government to various measures of inflation propagated all the great Latin American inflations of the relatively recent past, even as the Central Banks desperately hiked rates, didn’t buy securities, and, in general, did all they could to promote price stability.

China gives us an interesting contemporary data point to consider. Deficit spending in China has been running over 20% per year when you include state lending to state owned enterprises, local governments, and other entities where repayment isn’t a factor, making that lending, for all practical purposes, pretty much the same as deficit spending. The only time the US deficit spending got that high, with pretty much the same growth rates, was during World War II. And while considered high, China’s inflation seems to have peaked at about 6%, a far cry form hyper inflation, also, interestingly, much like the US during World War II. And note during World War II, the Fed was entirely accommodative, much like the the Fed is today, buying Treasury securities to keep long term rates low.

What all this tells me is that run away inflation, whatever that might mean, isn’t something hiding around every corner waiting to pounce. In fact, it takes a lot of work to get there, and not from the Fed, but from Congress. And not just what we’d call high levels of deficit spending, but ultra high levels of deficit spending.

I have no fear whatsoever of the Fed causing inflation. In fact, theory and evidence tells me their tools more likely work in reverse, due to the interest income channels. That’s because when they lower rates, they are working to remove net interest income from the private sector, and when they buy US Treasury securities (aka QE/ quantitative easing) they remove even more interest income from the economy. Remember that $79 billion in QE portfolio profits the Fed turned over to the Treasury last year? Those dollars would have otherwise remained in the economy.

So what’s the fundamental difference between what the Fed and can do and what Congress can do? The Fed can’t create net financial assets because they only buy, loan, and otherwise traffic in financial assets. Buying a bond or any other security only exchanges one financial asset for another and therefore doesn’t change the nominal (dollar) wealth of the economy. When the Fed buys a security, that security is no longer held by the economy. The Fed gets the security and the economy gets an equal dollar balance in a Fed account. The exchange is done at market prices so for all practical purposes it’s a equal exchange.

When Congress spends, however, it usually buys real goods and services, and not securities and other financial assets. So when the exchange takes place, Congress gets the real goods and services, which are not financial assets, and the economy gets dollar balances at the Fed, which are financial assets. So spending by Congress adds financial assets to the economy, to the penny, making it very different from what the Fed does.

And note that when the economy buys Treasury securities, all that happens is that the dollar balances the economy has at the Fed in what are called ‘reserve accounts’ get move to dollar balances in what are called ’securities accounts’ at the Fed. Dollars in securities accounts and reserve accounts are all dollar financial assets. So shifting back and forth doesn’t change the dollar nominal wealth of the economy.

In conclusion, theory and evidence tell me it’s impossible for the Fed to create inflation, no matter how much it tries. The reason is because all the Fed does is shift dollars from one type of account to another, never changing the net financial assets held by the economy. Changing interest rates only shifts dollars between ’savers’ and ‘borrowers’ and QE only shifts dollars from securities accounts to reserve accounts. And so theory and evidence tells us not to expect much change in the macro economy from these primary Fed tools, making it impossible for the Fed to create inflation.

Post Script:

And don’t be fooled by arguments centering around inflation expectations theory. That doesn’t hold any water either, and under close examination gets no support from theory or evidence. The only support it gets is from fundamentally flawed assumptions, which I’ll save for another discussion.

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5 Comments
  1. David Lazarus says

    I suspect that most intelligent observers are still wondering when the deflation of assets will continue. The Fed’s QE was to support the housing bubble and the banks that had lent to inflate that bubble. In that respect it has worked but the economy is still too weak to benefit from low interest rates. Long term the credit bubble is going to have to unwind and that means decades of debt repayment. If the deflation of housing resumes then banks will have problems. 

  2. Anonymous says

    I suspect that most intelligent observers are still wondering when the deflation of assets will continue. The Fed’s QE was to support the housing bubble and the banks that had lent to inflate that bubble. In that respect it has worked but the economy is still too weak to benefit from low interest rates. Long term the credit bubble is going to have to unwind and that means decades of debt repayment. If the deflation of housing resumes then banks will have problems. 

  3. Dani says

    What do you call $4/gallon gas? That’s not inflation? Of course the Fed will tell you it’s disruptions in Lybia and rains in Australia that cause commodity inflation, nothing to do with QE. But the stock market ripping, oh, that’s totally thanks to benevolent Ben’s money-printing. I’m still amazed by how journalists and the public at large don’t call out the Fed on this insult to our collective intelligence. It is a scam to focus on “core inflation” (ex food and energy) when the Fed’s policy clearly has a big impact on food and energy prices.

  4. Dani says

    What do you call $4/gallon gas? That’s not inflation? Of course the Fed will tell you it’s disruptions in Lybia and rains in Australia that cause commodity inflation, nothing to do with QE. But the stock market ripping, oh, that’s totally thanks to benevolent Ben’s money-printing. I’m still amazed by how journalists and the public at large don’t call out the Fed on this insult to our collective intelligence. It is a scam to focus on “core inflation” (ex food and energy) when the Fed’s policy clearly has a big impact on food and energy prices.

  5. Haris says

    I’ve read this argument and it makes a lot of sense but I am not so sure that it can explain away the rising inflation in certain commodities (mainly oil). Is Warren’s view that cost push inflation, or food & energy inflation, or whatever else you want to call it purely a function of misunderstood notions by the financial markets that the Fed is “printing” and therefore everyone is bidding up “real assets”. Is the entire market really that stupid that it is all one big misunderstanding?

  6. Haris says

    I’ve read this argument and it makes a lot of sense but I am not so sure that it can explain away the rising inflation in certain commodities (mainly oil). Is Warren’s view that cost push inflation, or food & energy inflation, or whatever else you want to call it purely a function of misunderstood notions by the financial markets that the Fed is “printing” and therefore everyone is bidding up “real assets”. Is the entire market really that stupid that it is all one big misunderstanding?

  7. Matt Stiles says

    Mosler just proved that he hasn’t even done minimal reading on the Austrian capital theory that underlies modern skepticism of central banks by those he portrayed as paranoid. 

    First, no self-respecting Austrian would accept Mosler’s definition of inflation, which appears to be CPI. 

    Second, Austrian aversion to interest rate manipulation is not simply that it causes inflation.  It is that changes in rate of interest skew capital allocation throughout the structure of production.  Usually, the major problem is that interest rates are kept too low for political reasons and therefore more capital is allocated toward short-term investments (ie. capital consumption) – and that creates price increases in related assets.  Meanwhile capital is withheld from longer-term investments and asset prices are suppressed or the assets fall into disrepair – making foreign competitors more productive and killing industry in the process. 

    It’s not about total inflation.  It is about each and every individual price that is different from “whatever it would be without the intervention” – and the signals those prices send to producers, consumers and entrepreneurs. 

    That is not to say “whatever it would be without the intervention” will necessarily be correct and everyone will start making hyper-rational decisions.  It is simply that the successes and failures will be determined by market forces rather than the strong arm of some central authority – liable to being co-opted by those with the most at stake.  More successes will be ethical and more failures will be deserved. 

    1. David Lazarus says

      I doubt that rising asset prices are good for society. If real estate rises it raises the costs for industry, even though it can be an appreciating asset for industry that owns it. For industrial firms that rent their premises it becomes a rising burden on the company. So forcing them to increase prices even if all other costs remain the same. That is cost push inflationary. For employees it drains them of disposable income as they have to pay more in rents or mortgage so increasing wage demands. In terms of share prices that is the accumulation of profits that is represented in the share price. Though the problem is the difference between tax rates of capital and income. It capital gains were taxed at higher rates than income companies would be more geared to boosting dividends than share buybacks to boost share prices, which is usually a significant benefit for managers on performance deals. 

  8. Matt Stiles says

    Mosler just proved that he hasn’t even done minimal reading on the Austrian capital theory that underlies modern skepticism of central banks by those he portrayed as paranoid. 

    First, no self-respecting Austrian would accept Mosler’s definition of inflation, which appears to be CPI. 

    Second, Austrian aversion to interest rate manipulation is not simply that it causes inflation.  It is that changes in rate of interest skew capital allocation throughout the structure of production.  Usually, the major problem is that interest rates are kept too low for political reasons and therefore more capital is allocated toward short-term investments (ie. capital consumption) – and that creates price increases in related assets.  Meanwhile capital is withheld from longer-term investments and asset prices are suppressed or the assets fall into disrepair – making foreign competitors more productive and killing industry in the process. 

    It’s not about total inflation.  It is about each and every individual price that is different from “whatever it would be without the intervention” – and the signals those prices send to producers, consumers and entrepreneurs. 

    That is not to say “whatever it would be without the intervention” will necessarily be correct and everyone will start making hyper-rational decisions.  It is simply that the successes and failures will be determined by market forces rather than the strong arm of some central authority – liable to being co-opted by those with the most at stake.  More successes will be ethical and more failures will be deserved. 

    1. Anonymous says

      I doubt that rising asset prices are good for society. If real estate rises it raises the costs for industry, even though it can be an appreciating asset for industry that owns it. For industrial firms that rent their premises it becomes a rising burden on the company. So forcing them to increase prices even if all other costs remain the same. That is cost push inflationary. For employees it drains them of disposable income as they have to pay more in rents or mortgage so increasing wage demands. In terms of share prices that is the accumulation of profits that is represented in the share price. Though the problem is the difference between tax rates of capital and income. It capital gains were taxed at higher rates than income companies would be more geared to boosting dividends than share buybacks to boost share prices, which is usually a significant benefit for managers on performance deals. 

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