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Is Pent-Up Inflation Likely?

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What comes first, the printing or the lending?

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Inquiring minds are wondering about the possibility of pent-up inflation from the massive expansion of money supply by the Federal Reserve. Our search for the truth starts with the question, "Which comes first: the printing or the lending?"

This is a critical question given the massive expansion of base money by the Fed as shown in the following chart.

Base Money Supply


Click to enlarge


Since the beginning of the recession, the Fed has expanded the base money supply from $800 billion to $1.7 trillion. Conventional wisdom suggests this money is going to come soaring into the economy at any second, causing hyperinflation on the notion that banks will lend out 10 times the amount of reserves.

So, is this pent-up inflation just waiting to break out?

Hardly.

A funny thing happened to the inflation theory: Banks aren't lending, and proof can be found in excess reserves at member banks.

Excess Reserves


Click to enlarge

Banks are Insolvent, Consumers Tapped Out

Because of rising credit card defaults, commercial real estate defaults, foreclosures, walk-aways, and other bad debts, banks need those reserves to cover future losses.

In practice, banks are insolvent, unable or unwilling to lend. Moreover, tapped out consumers are unable or unwilling to borrow. As a result, there have been spending collapses in all generation groups.

Bernanke can flood the world with "reserves" and indeed he has. However, he can't force banks to lend or consumers to borrow.

Yet every day someone comes up with another convoluted theory about how inflationary this all is. It's certainly "distortionary" in that it creates problems down the road and prolongs a real recovery by keeping zombie banks alive (as happened in Japan). However, it's not (in aggregate) going to cause massive inflation because it isn't spurring the creation of new debt.

Consumers and banks are both suffering from a massive hangover. Their willingness and ability to drink is gone. No matter how many pints of whiskey Bernanke sets in front of someone passed out on the floor, liquor sales will not rise.

In a debt-based economy, it's extremely difficult to produce inflation if consumers won't participate. And as noted above, demographics and attitudes strongly suggest consumers have had enough of debt and spending sprees.

Those pointing to flawed measures of money supply as proof of inflation just don't get it, and likely never will.


Banks Lend, Reserves Come Later


In practice, banks lend money and reserves come later. When defaults pile up, the Fed prints reserves to cover bank losses. Thus, those "excess reserves" aren't going anywhere. They're needed to cover losses. It's best to think of those reserves as a mirage. They don't really exist.

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