The Federal Reserve, the Great Recession and the Lost Inflation

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Ever since the Federal Reserve began its series of Quantitative Easings (QEs) traditional monetary economists have been predicting levels of inflation that would rival the inflation of the late 1970s and early 1980s. The three QEs resulted in a more than quadrupling in the level of Federal Reserve Assets. Moreover, during this same period, the monetary base grew at an astounding annual rate of 15.7 percent.

Our usual pre-Great Recession theory of monetary base growth and prices would have suggested that the greater than 20 percent growth in Federal Reserve assets and greater than 15 percent growth in the monetary base would result in at least double-digit inflation. But none of our dire predictions about inflation happened. In fact, the GDP deflator grew at an astounding low rate 1.4 percent. The question is why did the predicted inflation not occur? There are two unrelated reasons.

Reason One: At the onset of the QEs, the Federal Reserve began paying interest on bank reserves, making bank reserves liabilities of the Federal Reserve. As a result Federal Reserve asset growth net of these new liabilities was only 9.9 percent, less than half the growth in total assets. Further, since excess reserve holdings are part of the monetary base but do not contribute to monetary growth, the monetary base relevant for money growth must be adjusted for excess reserve holdings. This adjusted monetary base grew at only 7.5 percet and M2 grew at 6.3 percent. While both growth rates are significantly below the traditional base growth of 15.7 percent, both are still above the observed price level growth of about 1.5 percent, bringing us to Reason Two.

Reason Two: The historically low interest rates have resulted in unusually low levels of money velocity. The M2 velocity of money fell over this period at a rate of 2.9 percet per year. The traditional equation of exchange implies that the rate of inflation will equal the sum of the rate of monetary and velocity growth less the growth in real output. Thus, accounting for the fall in velocity coupled with the modest but positive growth of real GDP of 1.8 percent, suggests a price level growth of just over 1.6 percent, compared to the actual GDP deflator growth of 1.4 percent.

Thus, everything we thought we knew about money and prices  is still as relevant as ever. What is not as relevant as ever is our definition what should be included in what is often referred to as high-powered money, currency plus bank reserves. With the onset of interest payments on bank reserves, these reserves now compete with other bank investments. To the extent that banks hold excess reserves they reduce the monetary base relevant to price level determination. The growth rate of the adjusted monetary base coupled with the falling velocity of money restores the usual relation between money growth and prices.

Professor Thomas Saving, the Jeff Montgomery Professor of Economics, directs the Private Enterprise Research Center at Texas A&M University.

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