The Federal Reserve’s ongoing battle with inflation is set to have all the drama of a fight against Muhammad Ali. It could be like the 1974 “Rumble in the Jungle” where Ali, a 4-1 underdog entering the fight, dethroned George Foreman, the undefeated world heavyweight champion. Or maybe it’s more like Ali’s 1975 “Thrilla in Manila” where Ali and Joe Frazier met for the third and final time in what was perhaps the greatest boxing duel of all. time. Either way, the Fed’s opponent is tough and tenacious and Fed Chairman Jerome Powell will have to be just as tough and tenacious if he hopes to win this fight.
The irony of the current situation is that Powell’s opponent is the Fed’s own creation. The Fed’s massive stimulus immediately after the COVID19 shutdown was right on the money, but they were slow to normalize policy as the economy reopened and regained its footing. In fact, even as consumer prices began to boil over, the Fed continued to fuel the inflationary bonfire.
The extent of their largesse is clear when you look at the growth of the Fed’s balance sheet. In the 24 months between March 2020 and March 2022, the Fed purchased nearly $4.8 trillion worth of Treasuries and mortgage-backed securities. These purchases, known as quantitative easing, created a degree of stimulus to the economy far greater than the value of the bonds purchased. Here’s how it worked.
The Fed paid for its bond purchases by depositing reserves in the selling banks’ accounts with the Fed. Banks could then leave the reserves with the Fed at 0.10% interest, or they could lend them to businesses and consumers. Although interest rates on consumer and business loans were low, they were much better than what the Fed was paying, so the banks had a huge incentive to lend.
In our economy, bank credit is the main vector of money creation. You can get an idea of how it works by thinking of throwing a stone into a pond. The initial splash is followed by secondary waves that ripple across the pond. Along with quantitative easing, the Fed’s deposit of reserves caused a stir. As banks extended loans against these reserves, additional money was created and trickled down to the economy as borrowers spent the borrowed money on goods and services. The providers of these goods and services then used their income to buy the goods and services they needed. This cycle repeated itself, creating successive waves of economic activity all dating back to the Fed’s bond purchases.
The result is that the $4.8 trillion stone the Fed dropped into our economic pool has put much more energy into the economy than the original $4.8 trillion. It’s hard to quantify exactly how much, but we see evidence of this energy in the rapidly rising price of everything from financial assets and real estate to consumer goods and services.
Which brings us back to the fight against inflation. As long as these excess reserves are in the banks’ accounts at the Fed, they represent an inflationary impulse. The Fed can moderate this impulse by raising the interest rate it pays on reserves, making it more acceptable for banks to leave reserves in their Fed accounts. However, the real key to the long-term fight against inflation is to remove excess reserves from the system – a process called quantitative tightening.
Quantitative tightening can take place in two ways. These two options arrive at the same endpoint, but they get there by following slightly different paths. First, the Fed can sell its bonds directly to banks in exchange for excess reserves. Second, the Fed can let bonds mature. As Treasury bonds mature, the US Treasury will issue new bonds to pay the principal of maturing bonds. The new bonds will be sold to banks who will buy them using their excess reserves.
The net effect of quantitative tightening will be to reduce inflationary impulses in the economy, but it will also mean fewer reserves to lend to, which will mean slower money supply growth and a prolonged contraction of the economic stimulus. It’s going to be a tough fight. Let’s hope Jerome Powell and the Fed are up to it.