Phil Gramm Warns the Fed is Walking a Tightrope That Could Explode Inflation

Federal Reserve Board building, Washington D.C.

Phil Gramm, a former chairman of the Senate Banking Committee and Thomas Saving, a former director of the Private Enterprise Research Center at Texas A&M University, are out with an op-ed in The Wall Street Journal warning about the tightrope the Federal Reserve Board is walking.


The analysis provided by Gramm and Saving is technical in that it discusses excess reserves and the interest paid on them to commercial banks.

They write:

When the subprime crisis caused financial markets to freeze up in 2008, the Fed responded by pumping liquidity into the banking system. It also did something that was not widely discussed at the time and even a decade later is almost never taken into account: It started to pay interest on reserves, in essence paying banks not to lend.

Well, almost no one took notice, but I have regularly written about excess reserves, especially in the EPJ Daily Alert.

But the key point made by Gramm and Saving is that this trillion dollar overhang of excess reserves is a very tricky thing to handle, especially with the Fed now attempting to drain their balance sheet.

Like I said, the op-ed is mostly technical stuff but here is the money quote from the op-ed that everyone should be able to understand:

A small error by the Fed in following market interest rates could cause a large change in the money supply.

Yup, you read that right, given the trillions in excess reserves, one false move by the Fed and those reserves could explode the money supply.

Here's how Gramm and Saving explain what could happen if the Fed bends to President Trump's desires to keep interest rates low (my highlight):

If the Fed tried to keep interest rates low as credit demand rises amid the current recovery, the money supply and inflation would explode. While the Fed is not forever shackled by the monetary excesses of the Obama era, the sheer size of its asset holdings virtually guarantees that the Fed will feel the yoke of the massive excess reserves in the banking system for the remainder of this recovery.

For my part, I believe there already is enough money in the system to explode price inflation much higher, but Gramm and Saving are very correct that if a good chunk of excess reserves find their way into the system price inflation is going to really explode.

-RW