When ‘Money’ isn’t really ‘Money’

Since the financial collapse of 2007-2008 there has been a rapid increase in the U.S. monetary base and plenty of discussion about the impending hyperinflation. This is more prevalent in the U.S. than in Canada due to structural differences in our banking systems, but that would take more than 500 words to explain.

Today’s objective is to explain Mike Moffat’s recent article in the Globe and Mail. First, some definitions: Hyperinflation is a period of rapid, broad-based price increases, normally defined as inflation in excess of 50% per month. The monetary base is the liability of the central bank. This typically consists of issued currency plus reserve deposits of commercial banks. The money supply (M2) consists of currency in circulation (in the hands of the non-bank public) plus chequing and savings accounts at commercial banks and credit unions plus money market mutual funds. M2 is ‘money’ as a medium of exchange.

The Quantity Theory of Money tells us that there is a relationship between the money supply and prices. More specifically; the inflation rate will be equal to the growth rate of the money supply minus the growth rate of real GDP (gross domestic product).

The journalists and commentators that are predicting hyperinflation as a result of the Fed’s loose monetary policy are confusing the money supply with the monetary base. To maintain liquidity in the commercial banks, the Fed has been purchasing money market instruments – short term treasury bills and commercial paper off the market and paying for them with newly created reserve deposits. This action causes an increase in the monetary base. The commercial banks lost billions in the financial collapse and are still fighting liquidity problems. As a result, they have been increasing their reserves. When banks hold reserves and don’t lend them out, the monetary base increases, but the money supply does not. Inflation is caused by an increase in the money supply, not the monetary base. Until banks start lending these reserves, there is very little threat of inflation.

The Globe and Mail article suggests that the markets understand this even if the journalists don’t. The Fisher equation tells us that the nominal interest (the interest rate measured in dollars) is approximately equal to the real interest rate (purchasing power) plus the expected rate of inflation. Nominal rates for 10-yr treasuries are just under 2% at the time of writing. This implies that money market professionals do not expect to see inflation in the near future, regardless of what the commentators say.

At a dinner hosted by the Boston Fed last May, it was apparent that officials in the US are aware of the buildup in reserves and do actually have a plan to prevent inflation in the event that lending activity increases.

Until then, just remember, the sky is not falling … except in Russia.