The looming inflation

Arthur Laffer outlines the unprecedented expansion of the monetary base that the Federal Reserve has engineered:

About eight months ago, starting in early September 2008, the Bernanke Fed did an abrupt about-face and radically increased the monetary base — which is comprised of currency in circulation, member bank reserves held at the Fed, and vault cash — by a little less than $1 trillion. The Fed controls the monetary base 100% and does so by purchasing and selling assets in the open market. By such a radical move, the Fed signaled a 180-degree shift in its focus from an anti-inflation position to an anti-deflation position.

The percentage increase in the monetary base is the largest increase in the past 50 years by a factor of 10 (see chart nearby). It is so far outside the realm of our prior experiential base that historical comparisons are rendered difficult if not meaningless. The currency-in-circulation component of the monetary base — which prior to the expansion had comprised 95% of the monetary base — has risen by a little less than 10%, while bank reserves have increased almost 20-fold. Now the currency-in-circulation component of the monetary base is a smidgen less than 50% of the monetary base. Yikes!

The Fed thinks it can sop up the monetary excess when the time comes to ward off inflation. Laffer explains why it isn’t going to happen and adds: “For me the issue is how to protect assets for my grandchildren.” How about those of us who have to provide for ourselves?

JOHN adds: If banking in general and the Fed’s role in monetary policy are as fuzzy to you as they are to most people, you may find our podcast Ask the Economist illuminating. I’ll give away the ending, though: economist King Baniain thinks it is highly unlikely that the Fed will be able to carry out its metaphorical “sopping up” exercise so as to prevent damaging inflation some time in the next few years.

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