Saturday, July 11, 2009

Are Inflation Fears Real? An Economist Says No

Scott Fullwiler, an economist writing at the blog Economic Perspectives From Kansas City, observes that fears of inflation that have been expressed in various circles lately, all having to do with the large amounts of liquidity the Federal Reserve has pumped into the economy (you know, Obama’s economy recovery package?), are misplaced. In fact, he says,
As of July 2, 2009, the Fed reported the following assets on its balance sheet:

* Term Auction Credit: $283 billion
* Commercial Paper Lending Facility: $115 billion
* Central Bank Liquidity Swaps: $115 billion
* "Other" Loans (includes the Primary Dealer Credit Facility): $119 billion

Together, these assets amount to $632 billion. And what do they all have in common? They are all LOANS. Note also that they comprise the bulk of the $726 billion in reserve balances held by banks the Fed reports on its liability side.
Moreover, all of the loans in question are short-term, and have already been repaid.

The fear among Fed critics is apparently that the Fed lacks an “exit strategy;” i.e., it has no clear plan to counter the rise in reserve balances, which they claim will lead to inflation. Yet Fullwiler explains that
Banks DO NOT use reserve balances to create loans. They create loans and deposits simultaneously out of thin air. They use reserve balances to settle payments or meet reserve requirements ONLY. If a bank is short reserve balances for either of these purposes, the Fed provides an overdraft AUTOMATICALLY at a stated penalty rate, which the bank then clears via the money markets or the cheapest alternative. Whether banks in the aggregate hold $1 or $1 trillion in reserve balances, there operational ability to create loans is the same . . . infinite! (Though the creation of even 1 loan requires a willing, credit-worthy borrow in the first place, of course.)...That is how loan creation works in a modern monetary system. The belief that banks need reserve balances in order to lend is only applicable in a gold standard-type of monetary system.
In short, there’s no danger of inflation stemming from the Fed’s activities discussed above & there’s no need for an exit strategy.

Interestingly enough, Fullwiler observes that the financial press (he cites the Wall Street Journal specifically) doesn’t understand how the Fed works.

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