Picture of the Day: Why Inflation Isn't a Problem

The Federal Reserve has dumped trillions of dollars onto the financial system, and yet we haven't descended into a Zimbabwean nightmare of hyperinflation and toilet paper currency.

Why?                                                                                                                                      

This picture sums it up best:

This is the amount of excess reserves banks hold at the Federal Reserve. Notice the, um, slight bump in recent years.

Hoarders galore
What are excess reserves? Banks are required to hold a specific amount of cash at the Federal Reserve to back their deposits. Anything they choose to hold above that minimum is "excess" reserves. Banks typically don't want to hold much, if any, excess reserves because they could put the money to better use -- making a mortgage, a small business loan, whatever. That's why the long-term average hovers somewhere near zero.

That all changed suddenly and violently in the fall of 2008. After Lehman Brothers failed and credit markets froze up, there was a mass exodus from lending and an enormous propensity, on the part of consumers, businesses, and banks alike, to hoard cash. Banks wanted cash because they feared markets would shut down again; consumers wanted cash because they feared unemployment; businesses wanted cash to hunker down as customers fled. Everyone just wanted a bunker.

The Federal Reserve responded by flooding the financial system with money -- that's where you hear about "firing up the printing presses." The idea is that by increasing reserves, interest rates will fall, and consumers and businesses will be more enticed to borrow, expand, and get the economy moving.

Scared cashless
But reality was quite a bit different. No matter how much cash the Fed pumped into the financial system, banks haven't been given incentives to do anything but sit on their hands. They're too busy cleaning up losses and rebuilding capital. Excluding the effects of mergers, total assets at the largest banks, including Bank of America (NYSE: BAC  ) , Citigroup (NYSE: MS  ) , and American Express (NYSE: AXP  ) , aren't materially larger today than they were two years ago, given the amount of money pumped into the system. Some, like Goldman Sachs (NYSE: GS  ) and Morgan Stanley (NYSE: MS  ) , are actually considerably smaller today than they were two years ago after selling assets.

There's a telling quote in JPMorgan Chase (NYSE: JPM  ) CEO Jamie Dimon's letter to shareholders where Dimon notes that during the fall of 2008, there was such a tsunami of cash that "we barely knew what to do with it." The problem was that most banks didn't do anything with it -- other than maybe dump it into Treasuries -- which is why the Fed felt the burning need to slash interest rates and attract loan demand. The desire for banks to hoard acts like sugar in a gas tank.

Furthermore, consumers and businesses, on the whole, have a weak appetite for loans at any price because they're busy paying down debt and shell-shocked by the chaos debt caused last decade. It doesn't matter if interest rates are negligible -- and they are. The demand needed for loan growth just isn't there.

Bottom line: There's little propensity to make new loans, regardless of how much money the Fed pumps in.

So where does all that printed money go? It stays at the Fed, in the form of excess reserves. Hence the hockey stick in the chart above. This has been accentuated by the October 2008 ruling that allows the Fed to pay interest on reserves. Banks can now actually earn money by hoarding.

Why is that important when it comes to inflation? Because money sitting in reserves hasn't yet entered the economy. My favorite analogy for how printing money doesn't always equal instant inflation is that you can make as many bullets as you want, but those bullets won't do any harm until they're actually fired. Right now, the Fed has printed trillions of bullets, but almost none have been fired. They're all sitting idly in excess reserves.

Calm before the storm?
Someday, banks will gain confidence, businesses will regain the itch to expand, and reserves will weasel their way into the economy. That's when you need to worry. Until then, inflation will remain a non-issue.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. American Express is a Motley Fool Inside Value recommendation. The Fool has a disclosure policy.


Read/Post Comments (5) | Recommend This Article (26)

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  • Report this Comment On June 23, 2010, at 10:45 PM, sjoyner2 wrote:

    We definitely have a lot more problems than inflation to worry about. I read an article on the stock market and inflation on http://thepredatorsden.com/ which talked about pretty much the same thing.

  • Report this Comment On June 23, 2010, at 11:10 PM, brizzlekizzle wrote:

    Well I don't like to idea of inflation. I understand the point being made but I don't think that say 30 years down the road it will have as much merit, and the more this happens the more I stand by that. I think the title has truth in it, due to the fact that I can buy hard assets with intrinsic value that will rise in price in step with inflation. In fact, I think that in a scenario of long term inflation of 10% a year or so, these hard assets will be harder to get, temporally giving the owners an increase in purchasing power in addition to a rise in price due to more and more money chasing assets. When all the bullets have been fired, non indexed debt is easy and tempting to pay off with inflation, don't forget that.

  • Report this Comment On June 24, 2010, at 10:06 AM, crmeyer81 wrote:

    If there is no fear of inflation, then why are the charts for TIP, IEF, TLT and LQD are one of the best performing sectors?

  • Report this Comment On June 24, 2010, at 11:50 AM, TheDumbMoney wrote:

    Housel is my fave Fool writer!

    Another way of putting it is that because the bank's aren't lending money, the money multipliers are not expanding the money supply. Think of the money multiplier(s) simplistically in this way: The money the Fed "prints" is yeastless bread dough added to our economy-pan. Think of lending as yeast added to the dough, which vastly expands the volume of dough out there. Right now there is very little lending, despite all the dough the Fed has added to the pan. Thus, although the Fed is "printing" lots of dough, less lending means we really don't have have that much dough, compared to 2007, when the Fed was adding less dough to the pan, but the banks were adding a lot more yeast to whatever dough the Fed added.

    Inflation happens when too much dough chases too few goods. Not a problem we have right now.

  • Report this Comment On June 24, 2010, at 1:11 PM, joroi wrote:

    I get the premise of the article -- the lack of multiplier effect these days means no inflation is in the wings. What I don't get (or more appropriately, what I don't agree with) is the recommendation that typically follows such 'don't fear the inflation' rhetoric: namely, that the government should continue to spend the limitless money that the Fed is providing it with. All this Keynesian bs is why we can't shake-off this recession. In a normal business cycle everyone will go through a quick deleveraging phase, which would be typically completed within 6 months. Now we seem to be totally stuck. And our populist government keeps throwing gobbles of money after bad ideas... How is any of this helping us?

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