Where Dr. Paul's Inflation Might Be

Shikha Dalmia asked earlier today: "Where is Dr. Paul's Inflation?," focusing on the most recent measures of core CPI rise, which are not alarmingly high.

Economist Bob Murphy explained a few months back from a roughly Paulite perspective why he and others fear that the stunning rise in monetary base is indeed likely to eventually show itself in unignorable price inflation. While the numbers, as they always do, have shifted, the logic goes like this:

To understand the potential problem, we need to review some basic facts. Back in the fall of 2008, when Lehman collapsed and the entire financial system appeared in jeopardy, the Fed began bailing out investment banks through massive asset purchases and extraordinary lending operations. These activities rescued the major banks that would otherwise have gone bankrupt, by taking bad assets off their books (at inflated prices) and by propping up the new "market" price of the assets remaining on their books.

When the Fed buys an asset, it writes a check on itself. This action creates new electronic reserves in the banking system. For example, if the Fed buys $10 million in mortgage-backed securities from Joe Smith, then Smith will deposit the check in his own checking account. His bank will credit Joe Smith's checking balance by $10 million, but at the same time the bank'saccount with the Fed itself will rise by $10 million too.

At any time, regulations insist that commercial banks in the United States keep a minimum amount of reserves set aside in order to "back up" the demand deposits (think of checking accounts) of their customers. For example, if a commercial bank's customers think they have a total of $1 billion in their checking accounts, then the Fed's regulations force the commercial bank to keep (roughly) $100 million set aside in reserves….

Notice that "excess reserves" are historically very close to zero. This reflects the tendency (assumed in textbook discussions of "open market operations") for commercial banks to quickly lend out any reserves they have, over and above their legally required minimum. Yet as the chart above clearly indicates, since the onset of the present crisis the commercial banks have notbeen making new loans. Instead, they have allowed the huge injections of new reserves to sit parked at the Fed.

There are several (possibly overlapping) explanations for this break from the past. Keynesians such as Paul Krugman argue that this was the predictable outcome during a liquidity trap. Proponents of MMT (modern monetary theory) argue that the economic textbook discussions have things upside down, and that banks are never constrained by reserves when deciding on making new loans. Quasi monetarists lament the Federal Reserve's decision in October 2008 to start paying interest on excess reserves — a policy whereby the Fed actually bribes banks not to make loans to their customers. Free-market guys like Mish (as well as some card-carrying Austrians) have argued all along that significant price inflation was never on the table, so long as the financial system worked through a painful process of deleveraging.

Regardless of their specific explanations for why commercial banks hadn't been lending out the trillion-plus in new reserves Bernanke created, just about every pundit agreed that this fact was a major reason that what seemed to be incredibly inflationary policies weren't leading to skyrocketing prices.

Murphy thought back in August that the reserve-leaking was about to start happening in spades, which does not seem to be the case; in fact the latest figures show excess reserves continue to pile up, increasing by nearly 50 percent in the past year, as has the monetary base, by slightly slightly more. So as long as that leakage isn't actively happening, the inflationary effects predicted by Paul are staved off, goes the story.

And let us not forget the possibility of Cantillon effects, as Murphy says:

we must remember that there are millions of different prices in the economy. The specific impact of money creation on various sectors can be very different, and operate on different time frames.

For example, during the present crisis, we had the Fed create more than a trillion dollars on behalf of rich investment bankers. At the same time, middle- and lower-class households were plagued by high unemployment, large debts, and underwater homes. In this environment, it's not surprising that the various rounds of "quantitative easing" went hand in hand with huge jumps in stock and commodity prices, but were muted in the retail sector.

If and when the inflation arises, by the way, it will not be some nutty "lucky guess" by someone who just keeps repeating himself; it will because Paul (and the Misesian monetary tradition from which he derives) recognized what he saw as the necessary end of the process the Fed has been indulging in for years now. But there are reasons within the logic of the story (for which, admittedly, Paul is far from the most complicated and sophisticated explainer on the stump) that we aren't crushed by high inflation yet. (Though, as many in the comment threads pointed out, that core CPI figure doesn't match most people's experience actually buying the things they buy the most in the real world these days, food and energy.)