Inflation – What Inflation? by Elliot Eisenberg

by Elliot Eisenberg, Ph.D.

Over the last five years the prices of gold, silver and platinum have all risen dramatically out of fear that rampant inflation will appear. After all, the size of the Federal Reserve’s balance sheet has exploded from $800 billion in 2008 to $3 trillion today and will rise to $4 trillion by the end of 2013. Simple logic says that adding over $3 trillion dollars to the money supply in such a short time must create inflation. And, if inflation is not here now, it surely will be sometime in the near future, right? Maybe not.
Think about inflation like a racing car. For the car to go fast you need gas in the tank and a driver willing to put the pedal-to-the-metal. Absent either one, the car goes nowhere; same with inflation. For inflation to take hold, you need both an increase in the money supply and lots of bank lending. However, lending, for a number of reasons, has been chronically weak. Banks are fearful loans won’t be repaid; they are scared they will run afoul of new regulations, and more generally they feel that regulators don’t want them to lend. In addition, in 2009, 2010 and 2011 banks were hard at work fixing their own balance sheets and were really not in a position to extend credit. Returning to our racing car analogy, the driver is pressing the gas pedal very gingerly.
To give you a feeling for how lightly the gas pedal is being pushed, the velocity of money, or the number of times a dollar circulates before it comes to rest, has (along with other similar monetary measures) tanked. Before the Great Recession, the velocity of M1 (cash) was 10.5, it’s now 6.5, while for M2 (cash and checking accounts) it declined from 2.1 to 1.5. These are dramatic declines.
Inflation hawks contend that it’s just a matter of time before inflation inevitably appears. I don’t think so, and here’s why – when bank lending returns to historic levels, Bernanke and the rest of the interest-rate setting Federal Open Market Committee (FOMC) will start to shrink the money supply to counteract the increased lending. The first thing the FOMC will do is announce that the current bond buying program will end. Then it will announce that interest earnings on its huge holdings will not be reinvested, but rather will be stored in the vault as will principal repayments from maturing bonds. The Fed will then start to raise short-term interest rates and finally it will begin to liquidate its vast holdings of mortgage-backed securities and long-dated Treasuries in an effort to chronically shrink the money supply.
Of course the Fed will not perfectly time each phase in this contractionary fiscal policy program. If they tighten too quickly, it will result in weak quarter or two of economic growth. And if they tighten too slowly, a bit of inflation may result. In either case, no systematic increase in inflation should be expected because the Fed is preoccupied with this issue and because investors expect the Fed to be vigilant about keeping inflation tame.
Elliot Eisenberg, Ph.D. is President of GraphsandLaughs, LLC and can be reached at His daily 70 word economics and policy blog can be seen at