Janet Yellen, like Ben Bernanke before her, believes that the Federal Reserve should communicate the reasons for its current policies and the strategy of its future policy actions. And so we have been told the basic plans are for gradually reducing the volume of large-scale asset purchases, and for keeping short-term interest rates low—"for some time," as she said in her speech on Monday—in order to stimulate employment and raise the inflation rate toward 2%.I have been saying pretty much the same thing in the EPJ Daily Alert. Of note, the price inflation reading on the MIT Billion Prices Index is showing a rate of 5.93% annualized. The index has been pretty volatile recently, but this number is worth noting, as in the past it has tracked the CRB Index fairly closely and for some reason it is now wandering by itself on a general trend upward.
But the Fed's leaders should also be telling the public and financial markets what they think about the risk that future inflation could rise substantially above the Fed's 2% target—and what the Fed would do to prevent such inflation or reverse it if that occurs.
Experience shows that inflation can rise very rapidly. The current consumer-price-index inflation rate of 1.1% is similar to the 1.2% average inflation rate in the first half of the 1960s. Inflation then rose quickly to 5.5% at the end of that decade and to 9% five years later. That surge was not due to oil prices, which remained under $3 per barrel until 1973.
Feldstein goes on to say:
Although history teaches that a rapid expansion of the money supply leads eventually to rising inflation, the current inflation risk is not, as many people assume, that the Fed's policy of quantitative easing has greatly expanded the money supply. Although the commercial banks received trillions of dollars of reserves in exchange for the assets that they sold to the Fed, these reserves were not converted into money balances but were deposited at the Federal Reserve, which now pays interest on such excess reserves. The broad money supply (M2) increased only about 6% in the past year.
The real source of the inflation risk is that the commercial banks can use their enormous deposits at the Fed to start lending when corporate borrowers with good credit ratings are prepared to borrow. That increase in lending to businesses will be welcomed until the economy is back at full employment.
I was among the first to point out that the Fed expansion of the monetary base was not leading to an equal amount of expansion of the money supply, so I agree with Feldstein on this point. But the method I use to calculate money growth for the ALERT is different from the measure Feldstein uses. My method of calculating money growth shows that at the start of 2014, it was as high as 9.0% on an annualized basis. It has since slowed dramatically which is why last week I started advising in the ALERT that traders start to lighten their stock market positions.
Another point where Feldstein and I differ is on what might trigger price inflation from here. He seems to think it will only occur if the money supply expands at a greater rate from the present. This is a very mechanistic way to think about the relationship between price inflation and money growth. It reminds me of the way Milton Friedman thought about money supply growth and inflation and which resulted in his getting egg all over his face, when he predicted soaring price inflation in the late 1980s because of climbing money supply, but the price inflation never occurred.
It is only economists of the Austrian school who understand that the desire to hold cash balances also plays an important role in price inflation (as well as changes in productivity), in addition to the role of money growth itself. If the desire to hold cash balances climbs, it will suffocate any price inflation that might be caused by an increase in the money supply. If the opposite occurs and the desire to hold cash balances declines, it will act as an accelerant to any price inflation that might result from an increase in the money supply.
As the Austrian economist Hans-Hermann Hoppe notes in Economic Science and the Austrian Method:
It is possible to make the wrong prediction in spite of the fact that one has correctly identified the event “increase in the money supply” and in spite of one’s praxeologically correct reasoning that such an event is by logical necessity connected with the event “drop in the purchasing power of money.” For one might go wrong predicting what will occur to the event “demand for money.” One may have predicted a constant demand for money, but the demand might actually increase. Thus the predicted inflation might not show up as expected.Hoppe's "demand for money" is what I call the desire to hold cash balances. For a number of reasons which would require too much detail to put in this post, I suspect, and there is no empirical way to measure this with absolute certainty, that the desire to hold cash balances is declining. If it is, there is enough new money already printed by the Fed to really get the price inflation ball rolling.