Max Gillman on The Spectre of Price Inflation

“Why are prices so high? Is this a temporary spike due to Covid or the war in Ukraine?”

In my new book, The Spectre of Price Inflation, I argue that our current predicament of price inflaction is unlikely to be a short blip and to understand it we need to look back on banking and monetary history. The quantity theory of money (often ignored in a period of crisis and war) is alive and kicking, and the price inflation that we are experiencing now is a predictable result of money leaving bank reserves held at the Fed and entering circulation rapidly.

From the end of the Bretton Woods gold standard in 1971 until 2007, the Federal Reserve bought U.S. Treasury debt at about a 2 percent rate—essentially printing money. No longer backed by gold, the dollar’s value is by “fiat,” so the Fed can print as much money as it wants. The inflation rate target is designed to keep the money supply under control, with the idea that inflation (which you can also consider a tax) would be low and stable.

Money printing is much more literal than you might think. The amount of dollars in circulation from the 1970s to 2008 almost exactly matches the amount of Treasury debt bought and held by the Fed. This money-printing process involves the Fed giving freshly minted dollars to the Treasury to cover its deficits, albeit first being channeled through banking intermediaries, who earn a commission for this cash transfer from one branch of the U.S. government to another, as Milton Friedman put it.

If dollars were the only money that circulated, such a Fed policy would have resulted in a near zero inflation rate, since the U.S. economy has grown at about 2 percent a year for the last century. However, private banks also create money through deposits from bank loans or money market investment accounts that enter circulation when they are spent. Adding this private bank money used for transaction purposes to the currency supply has doubled the total money in circulation. As a result, the money supply grew 2 percent more than the economy did, giving us an average 2 percent inflation rate per the Fed’s target.

So what changed? to create the current spike in inflation? The answer is that the Fed began paying interest on reserves that private banks kept in the Fed in 2008, regardless of how much money that was. Before 2008, banks generally held the absolute minimum of money as reserves at the Fed according to their legal obligations. This amounted to only 1 percent of all commercial bank deposits in 2007. When the mortgage loans defaulted in 2008 and the investment banks holding this debt withdrew their reserves from the Fed to pay out depositors, the Fed found itself with negative reserves.

To stem this crisis, the Fed began paying banks to not withdraw their reserves, effectively paying them interest on their holdings. The banks were first paid for the interest and principal of the Treasury debt when they sold the debt to the Fed, and they then were paid interest a second time when the Fed began its new policy of paying interest on reserves. Unsurprisingly, banks responded favorably to this subsidy, and almost all Treasury debt bought by the Fed after 2008 was kept in the Fed’s vaults as excess reserves. This money did not enter circulation, so inflation remained stable. In 2015, the Fed began raising the rate of interest paid on excess reserves; banks responded by gradually began lending them out. As these reserves entered circulation after being quarantined at the Fed for some six years, the inflation rate rose modestly from 2015 to 2018 from zero to 2.5 percent.

This is the key to today’s problem: it was only once these excess reserves entered circulation that the inflation rate began to rise. After 2020, the Fed accelerated its purchase of Treasury debt again. Its reserves rose by one trillion dollars more than the previous height of 2014, and this time the reserves entered circulation much more quickly. Inflation went from zero percent in 2020 to 8.5 percent in 2022. This increase occurred because the Fed bought Treasury debt at a faster rate than banks were willing to keep the money sterilized at the Fed, creating a gap. Inflation took off in 2020 as the initial 2020 build-up of reserves was lent out and entered circulation at a faster rate than in previous years.

The problem with the Fed’s post-2008 policy of paying interest on reserves—besides diverting inflation tax revenue from the Treasury (taxpayers) and handing it to private banks—is that we never know exactly when banks will decide to loan out their huge reserve pot. This makes predicting inflation dependent on predicting how much reserves banks will hold at the Fed, in addition to the age-old concern of how much money the Fed will print by buying Treasury debt to finance large government deficits.

The figure below shows the build-up of new reserves, followed almost exactly in line with the money printed by the Fed buying Treasury debt from the private banks. Normally, banks lend out all reserves as soon as possible and hold zero excess reserves at the Fed, as was the case before 2008.

A disconnect between the money supply growth and the inflation rate thus appeared. Since hardly any of this new money created after 2008 up to 2014 entered circulation, the inflation rate did not rise.

Once the reserves began to be lent out, the money entered circulation. The figure clearly shows that the reserves began falling after 2014, when the Fed started to raise the interest rate paid on reserves in December 2015. The Fed in effect supplied an unending subsidy to private banks as insurance after the investment bank sector collapsed in 2008

“The Fed in effect supplied an unending subsidy to private banks… A pay-out for a car crash that happened while they were uninsured!”

The subsidy was the interest paid on these reserves. The Fed also bought up the class of assets—mortgage-backed securites (MBS)—that had caused the investment banks to collapse in the first place to the tune of billions of dollars. Conflating monetary policy with bank insurance supplied after the crash, the Fed bought huge swaths of Treasury debt, increased the money supply dramatically, sterilized the increase in money supply up to 2014 completely, set international short-term market interest rates below the inflation rate, induced internationally adopted negative real interest rates on short-term Treasury debt, distorted capital markets, and paid banks not to lend out money for investment. In so doing, the Fed created the moral hazard of a poorly designed bank insurance policy that induced less investment and greater financial risk-taking.

Portfolio managers took on greater risk/great yield assets to offset the negative return on the “risk-free” Treasury debt. MBS were bought up by three times the previous amount because the Fed forced down market interest rates by flooding the market with new money after the 2001 World Trade Center terrorist attacks. Three years of negative real Treasury interest rates after 9/11 induced the flight towards MBS. When the Fed decided to quickly “normalize” market interest rates and raised the federal funds rate from 1 percent in 2004 to 5.24 percent in 2006, mass default on mortgages resulted, with the collapse of MBS investment banks occurring two years later.

After 2008, the Fed set the interest rates in international capital markets by diktat. Why the international markets? Because dominant Western economies emulated U.S. policy to replicate the same negative short-run real interest rates so that their currencies would not appreciate relative to the U.S. dollar.

International capital markets were thus distorted by inducing greater risk. The moral hazard is that the international financial system has been “seeking yield” through riskier portfolios while expecting to be bailed out if a new financial crisis occurs. This expectation is in lieu of having an efficient bank deposit insurance system put in place systematically.

“Central banks should go back to their objective of targeting a low inflation rate and avoid meddling in and subsidizing banks through inefficient bank insurance that distorts global capital markets.”

My book, The Spectre of Price Inflation, traces these events. It also sets out how efficient banking insurance might be established to untangle the current monetary and banking insurance policy (which goes by the name “macroprudential policy”). Central banks could then return to their objective of targeting a low inflation rate and avoid meddling in and subsidizing banks through inefficient bank insurance that distorts global capital markets.

The Fed was only able to suppress inflation so long as private bank reserves stayed locked at the Fed. This strategy failed in 2020 and after when the Fed printed money at a dramatically accelerated rate. This increase of money flooded into circulation, driving up the money supply and the inflation rate—just like the age-old quantity theory of money predicts.

Max Gillman is Friedrich A.Hayek Professor of Economic History at the University of Missouri–St. Louis and the author of The Spectre of Price Inflation