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.
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.
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.
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.