Reading time: 5 – 8 minutes

In a lead op-ed editorial in the Wall Street Journal on July 21, 2009, Federal Reserve Chairman Ben Bernanke revealed the Fed’s exit strategy concerning the inflationary effects of the Obama “spending is stimulus” packages and other government measure to contain the current crisis.

This article is mandatory reading for anyone interested in the future of the US economy.

Sweeping up worthless currency: Hungary 1946.

Inflation? No problem?

First of all, the Federal Reserve Bank does not foresee inflation as a problem in the immediate future:

As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period.

This seems to reflect the Carter-era mistake of confusing economic recovery (measured in terms of employment and business activity) with inflation.

Sterilizing excess dollars

The most powerful tool that a central bank has to sop up money created by excessive government spending is to increase mandatory, non-interest-bearing reserve requirements of depository institutions.

This method has the potential of effectively “sterilizing” money that the government deposits in bank accounts in payment of imprudent Congressional spending, while reducing interest charges on government deficits.

In the United States, however, in response to lobbying of the banking industry, plus regulatory confusion between banking and the securities market, the Federal Reserve’s powers in this area have been dramatically reduced.

1. Most “bank deposits” are now with money market funds, rather than banks, thereby escaping Federal Reserve control. (See: Money Market Funds will tell us when inflation is here. )
2. Since the early 1990s, mandatory bank reserves have fallen sharply. In 1990, reserve requirements on large time deposits were eliminated. In 1992, reserve requirements on transaction accounts were reduced. Banks have introduced “sweep accounts” which automatically transfer funds from regular deposit accounts to time deposits or money market funds, both exempt from reserve requirements.
3. The largest portion of mandatory reserve requirements that now remain are relative to vault cash or purely operational needs of banks, having little effect on the money supply.

Dependence on Congress

For the Federal Reserve to effect changes that would restore its powers to neutralized excess government spending, it would need to go before Congress and obtain such authority.

There are four formidable barriers to restoring such powers:

1. Opposition from the powerful banking lobby.
2. Opposition from factions seeking to reduce Federal Reserve power in general.
3. Opposition from undeclared factions favoring “easy money” and currency devaluation as a means of reducing debt burdens on a profligate population.
4. Opposition from the securities industry and securities regulators who will fight to keep money market funds away from the powers of the Federal Reserve.

Perhaps recognizing the impracticality of having anti-inflationary powers restored by Congress, Chairman Bernanke has focused on using the newly granted powers of paying interest on bank reserve requirements as a means of controlling the money supply.

In other words, Bernanke has effectively taken “The Nuclear Option” off the table as a tool to fight inflation. (See: How the US may avoid inflation: The Nuclear Option. )

Fiddling interest rates on bank reserves

According to Chairman Bernanke’s WSJ article, the primary inflationary threat comes from excess bank deposit with the Federal Reserve resulting from government actions taken to stimulate the economy in the early stages of the crisis.

These emergency reserve-producing actions consist of such things as the Fed acquiring securities and loans from banks to provide liquidity support in the immediate crisis.

Such amounts on the Fed balance sheet are now more than $800 billion above “normal” levels. Of course, these balances must be worked off.

The MMF loophole

However, most of the Obama “spending is stimulus” measures have not yet reached the stage where funds have been disbursed.

As this happens, money will enter the banking system and will be swept into money market funds and time deposits, exempt from Fed banking reserve requirements.

Money market funds in particular are a parallel banking system outside of Fed control. With no reserve requirements, while presenting all the features of demand deposits, these funds have the potential to be highly inflationary due to the “multiplier effect”.

Fighting inflation by increasing debt?

Chairman Bernanke’s plan is to use the newly granted power of paying interest on bank reserve requirements as a sort of free market enticement that will attract bank reserves to federal control.

This, of course, has an obvious, glaring disadvantage compared to traditional mandatory non-interest bearing reserve deposits — the interest paid by the government will add to the government debt burden at a compound rate.

Increasing the interest rate on federal reserve deposits will contribute to higher interest rates throughout the economy — a typical effect of inflation, while increasing the cost of doing business — a measure to reduce economic activity. In other words, a recipe for stagflation.

Selling the world on the Fed’s strategy

Another problem with Bernanke’s formula is that unless the Fed takes decisive, believable actions against inflation, primary buyers of government securities — holders of debt representing the accumulated trade deficit — will shun government securities and move into non-financial assets. (See: How long will it take to work off the US trade deficit?)

Finally, the Bernanke formula seems to ignore the fact that interest rates are not the sole, or even primary determinant of money flows in an inflationary environment.

In an open, global economy, funds will flow out of the United States to economies with stronger currencies.

Of course, before we get to the point that inflation begins to kick in, management of the Federal Reserve may change — for better or worse. Furthermore, with the popularity of the Obama administration teetering over reactions to the “spending is stimulus”, “cap and trade”, and Obamacare packages, there is no assurance that current policies, for better or worse, will persist.

These are trying times.

How would you interpret this?