3.19.2009

Drowning in a Flood of Fed Paper

The Federal Reserve announced yesterday that it is effectively doubling the amount of money in the financial system by injecting the massive sum of $1.2 Trillion. The current monetary base is approximately $1.5 Trillion. According to the Washington Post:
The new purchases come with risks. They will balloon the value of the assets the Fed holds by about 50 percent, to more than $3 trillion. That could make it tricky for the central bank to draw that money out of the system once the economy starts to recover. The Fed would probably find it difficult to sell such massive volumes of assets, and if it doesn't handle the task adeptly, the nation could face high inflation because too much money would be in circulation.
Another blogger pointed to the St. Louis Fed's own data recently, showing this startling graph of the historical growth of the money supply. Note how George Hoover Bush kicked off the recent flood before the election. (the gray bars are periods of recession)
Today, I modified the graph to include the Consumer Price Index as well, just to get a sense of how inflation has tracked with the money supply. I used a log scale on the Y-axis to get a better sense of the comparison:
The money supply and the CPI track pretty well over time, especially since the abandonment of the gold standard. But look at the spike in the money supply recently, one that hasn't yet had time to have an impact on the CPI.

If we go back to a regular scale Y-axis (the billions of dollars in the system), and then do a simple projection based on yesterday's news, we're left with:
Scary, isn't it?

An article in The Economist spells out the potential consequences of this rash act by the Fed:
Taking the added step of buying Treasuries made some inside the Fed uncomfortable. It amounts to monetising government debt—in essence, allowing the government to finance its spending with newly printed money rather than by borrowing or through higher taxes. That raises two fears: that it would eventually lead to inflation, or even hyperinflation, and that it would compromise the Fed’s independence. [bold added]
The concern over hyperinflation -- picture Germans in the mid-1930s with wheelbarrows full of paper money hoping to buy bread, or more recently, what is happening in Zimbabwe -- is hopefully as remote as The Economist makes it out to be. But it does mention that the Fed "sees some risk that inflation could persist for a time below [its preferred rate]." The Economist also makes a good observation:
The plans are awe inspiring in their scale, but they are different only in degree rather than kind from the steps the Fed has already taken.
The Fed is staying true to its script, just like the Obama administration. The mantra that is repeated endlessly in Washington is "we have to do something!" and the only guidance anyone there has is Pragmatism. Don't look at history, don't do what is right; just do something, anything! that might work right now. What will happen in 9 months? Who cares? As an economist from Credit Suisse was quoted in the Washington Post article, "When the house is burning down, you put out the fire. If in the process you get the furniture wet, you worry about that later."

I could be wrong, but that analogy just makes me think of putting the entire U.S. economy on the block in a fire sale. Not to worry, though. Good old John Maynard Keynes gave us the guidance we need when he said "In the long run, we'll all be dead." Indeed, Johnny. Indeed.

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