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The Federal Reserve has a dual mandate: maximize employment and keep inflation in check. As it meets Tuesday and Wednesday to plot its next moves to stimulate the economic recovery, unemployment is still above 7 percent, so that’s still a problem.
But inflation? The August figures released Tuesday show consumer prices rose 1.5 percent in the past 12 months. That’s well below the Fed’s target rate of 2 percent, so there’s hardly a threat of runaway prices.
One might ask why inflation is so low, given that the Fed has printed and spent some $3 trillion in the past five years. It pumped those funds into the banking system through a bond-buying program known as quantitative easing.
You might remember from Econ 101 that when the government prints money willy-nilly and the money supply increases, it can cause inflation. (Take the case of Zimbabwe, though there are also other causes of inflation.) Some critics warn that the Fed is playing with fire by flooding the system with easy money.
So why has there been virtually no inflation and why do so few experts expect it any time soon?
“Because this is $3 trillion that never left the building,” explains Jim Paulsen, chief investment strategist at Wells Capital Management.
The Fed handed over all this money to the banks, hoping they would lend it out. But the banks aren’t doing much with it.
“Most of it hasn’t even touched the economy,” Paulsen says. “They’re being held in excess reserve at the Federal Reserve.”
Excess reserves are sort of like savings accounts banks keep at the Fed. So why are banks holding on to the money?
“It’s a combination of some banks are still reluctant to make loans, and some of it is businesses and families that used to come to the banks for more loans, they’re not coming to demand the loan,” says Matthew Slaughter, a professor at Dartmouth’s Tuck School of Business.
Keith Leggett, vice president and senior economist at the American Bankers Association, says banks are more growing more eager to lend.
“All evidence is indicating that banks are beginning to relax underwriting standards. Terms of credit are becoming easier, so on the supply side things are improving,” he says. But “it’s still a challenge” to find creditworthy borrowers, and many businesses aren’t confident enough to borrow funds to expand.
But that’s today. What happens if the banks decide to start lending out all that money they have lying around?
That’s when the specter of inflation might rise. If those reserves finally do start to flood the economy, the Fed will have to take money out of circulation.
“A big part of the Fed’s exit strategy, which will make tapering that everyone’s talking about look trivial and unimportant, is how and when to judge that it’s time to start withdrawing this liquidity from the banking system,” says Alan Blinder, a Princeton economist and former Fed vice chair.
The Fed withdraws money by selling the bonds and securities it had bought or letting them mature. It then destroys the proceeds, thereby reducing the money supply.
Doing that at exactly the right pace is beyond human ability, says Blinder, so “the Fed is gonna have to make judgment calls about where it wants to take chances.”
If the Fed reduces the money supply too fast, it might stunt the economy. If it goes too slow, it could let inflation sweep in.
“That’s gonna be a really critical set of choices for the Fed,” Blinder says.
But not today.