Inflation Watch as Fed Hawks Retire

What is the prognosis for inflation, now that two hawks at the Federal Reserve are about to step down?

Charles Plosser is set to retire from his post as President of the Federal Reserve Bank of Philadelphia March 1, and Dallas Fed President Richard Fisher will be required to retire next April due to Fed rules. Both have been prominent dissenters on the Fed’s historic low rate policies and money printing to buy federal and private sector bonds in order to keep mortgage rates low, with repeated concerns and warnings about inflation.

The rising tide of Fed and fiscal stimulus papered over slack demand in the economy, in this Walter Mitty upside down world of a government response to a poor economy.  Meanwhile,  corporate executives and taxpayers alike still have to pull on the fishing waders to slog through the U.S. tax and regulatory morass,  slowing down growth (http://www.basspro.com/Fishing-Waders/_/S-12500003001).

So if you’re worried about inflation--the Federal Reserve’s preferred measure rose a tame 1.6% in the year through July--the data point to watch is the M2 money supply figure published by the Federal Reserve, not the monetary base or the Fed's $4.42 trillion balance sheet, now about twice the size of France due to the Fed’s bond buying program to help drive the overnight federal funds rate down towards zero. M2 is a measure of money supply that includes cash, checking and savings deposits, money market mutual funds and other deposits that can be quickly converted into cash or checking deposits.

Of course, banks have not entirely lent out their $2.5 trillion in excess reserves created by the Fed’s bond buying program, called quantitative easing (QE), which ends next month. After the Fed turns off its liquidity hydrants, rate hikes are next, with expected rate rises coming next spring. “That's why inflation has remained low and all the hyperinflationist types have been so wrong,” says economist Brian Wesbury (for more, see here: http://www.foxbusiness.com/2014/08/13/hyperinflation-spook-story/).

Wesbury points out that the monetary base has grown about 32% annually since the Fed acted to stop the effects of the financial collapse in 2008 (http://research.stlouisfed.org/fred2/series/BASE/).

However, M2 has grown at a fifth of that rate, at about 6.7% per year (http://research.stlouisfed.org/fred2/series/M2/). “So, QE is not the reason for the rise in stocks, or the growth in the economy.  Ending QE will not cause a crash or recession,” Wesbury says.

Once the Fed’s bond buying program ends, its rate policies and their effect on the economy will take center stage.  Will the banks start lending out their excess reserves starting next spring, triggering inflation?

“It is almost certain they will become more aggressive about lending even as they move up their expectations of when and how much short-term rates will rise,” Wesbury says. “This, in turn, would boost the money supply sharply, driving up asset prices, economic activity and inflation in the months and years ahead.”

More so, given the fact that it is feared the Fed has lost control of the fed funds rate, which moves higher or lower as a function of the central bank’s bond purchases. The Fed does not pay interest on the reserves held by government sponsored Enterprises (GSEs) like Fannie Mae and Freddie Mac. So, those reserves, too, could come into the system if Frannie lends them to banks.

What’s putting a lid on lending out those reserves? For one, the central bank has already warned those reserves are temporary, banks really can’t lend out temporary funds, and the Fed can neutralize these reserves in open market operations. But banks have been sitting on reserves because of government regulation. “Dodd-Frank hyper-regulation and new capital standards have squeezed banks' desire to leverage their balance sheets,” Wesbury explains.

And why make long-term loans, using reserves, now when there is not much to be earned, given how low interest rates are?  The Federal Reserve has been paying interest to the banks on their reserves at a marginal rate that beats the rate they would get on Treasury bills.

As for the Federal Reserve unloading the bonds on its balance sheet, Federal Reserve chair Janet Yellen says "it could take until the end of the decade" to shrink the Fed’s historically high bond portfolio to more normal levels, which could keep yields on bonds low for now, as well as resulting borrowing costs. That could aid and abet the federal government too in its spendthrift policies, as federal debt has doubled since 2008, the year the central bank launched its record quantitative easing (see here: http://econbrowser.com/archives/2014/08/what-did-quantitative-easing-accomplish).