How much money can the Fed create without stirring up rapid inflation and sharply devaluing the US dollar?
It’s an “unanswerable question,” says a Federal Reserve economist, speaking on background. Yet government policymakers – and many others – would dearly like a definitive reply.
Here’s why: The nation’s central bank is stoking the US economy at an unprecedented rate. In one year, it has more than doubled its balance sheet and now holds $2.2 trillion in assets. It aims to buy nearly another $1 trillion in securities – over and above the $787 billion in Treasury stimulus and billions more to save General Motors.
In normal times, such a massive infusion of spendable money would be reckless, fanning inflation and devaluing the dollar by tempting investors to unload greenbacks around the world. But these aren’t normal times.
With the economy stuck in the deepest recession in at least 50 years, factories and other firms have oodles of spare capacity and unemployment is high. These factors point toward lower inflation, not higher inflation. “Inflation is way down on my list of worries right now,” says David Wyss, chief economist of Standard & Poor’s in New York.
But many economists do worry about what happens to inflation after the economy fires up again. Will the Fed pull money out of the system by boosting interest rates? Will banks leave extra money in their reserves or loan it out? Will companies and individuals boost savings – or go on a spending spree?
One minority view is that inflation will remain benign even then. When the Fed started last October to pay interest on reserves of cash held by banks, it altered the nation’s economic equation, argues Robert Hall, an economist at Stanford University and chairman of an economists’ committee that dates the start and end of recessions. Should banks continue earning competitive interest rates on their reserves, they will have less incentive in loaning them out and stoking inflationary flames.
“There is no risk of excess inflation in today’s economy,” he states in an e-mailed analysis with another economist, Susan Woodward.
A more common view is that the US central bank will have to withdraw money from the economy at some point. Fed Chairman Ben Bernanke himself has told congressional lawmakers: “We understand the necessity of winding this down at the proper moment so we will not have an inflation problem on the other side.”
But it’s a tricky operation. “There is no mechanical, fixed relationship” between the growth in money supply and future inflation, says Mr. Tilton. So the Fed will have to guess at the timing.
Some economists are pessimistic. “The Fed is going to be fearful of acting too soon, of choking off the recovery,” says Paul Kasriel, an economist at Northern Trust Co., a Chicago-based bank. So it’s “likely” to take money out of the economy too late, thereby leading to more inflation in perhaps two years and devaluing the dollar.
Mr. Wyss cheers the Fed for its bold moves to boost the economy. By contrast, he adds, the Bank of Japan in the 1990s was so worried by the risk of inflation it was too modest in fighting recession, resulting in 15 years of declining prices.
By the way, the Fed normally earns huge profits on its assets. But many of its newly acquired ones pay barely any interest (0.25 percent). So there’s no big boost to Fed profits in the offing.