High Inflation Still Unlikely

Ever since Federal Reserve Chairman Ben Bernanke commenced quantitative easing in October 2008, many commentators have warned about the danger of inflation. There are good reasons to be concerned-including the unprecedented expansion of the monetary base and the Fed's bloated balance sheet-but many Fed watchers are fighting the last war.

The financial crisis has brought such major changes in central banking that uncontrolled inflation from discretionary monetary policy is not as great a danger as it once was. The Fed now has a variety of exotic tools that can prevent any sudden expansion of the broader monetary measures. These tools are partly what have already prevented quantitative easing from causing serious inflation.

Moreover, the Fed monitors banks and other financial institutions so closely that it cannot be caught napping, and implicit inflation targeting has become a dominant Fed goal. The real danger is not runaway inflation. It's that the Fed is becoming more and more intrusive in shaping how national savings are allocated.

The prevalent worry is that once the economy gets back to normal and interest rates start to rise, banks will increase their loans. And when that happens, many fear, the Fed has no viable exit strategy to hold back inflation.

Central banks traditionally dampen inflation by reducing the monetary base via selling off assets or, equivalently, calling in and not rolling over loans. Those who predict future uncontrolled inflation believe this cannot be accomplished quickly enough without major disruption of credit markets. Aggravating this problem is that the Fed's balance sheet now contains large quantities of mortgage-backed securities and long-term Treasury debt, not just the short-term Treasury securities that were its primary asset in the past. The Fed can quickly reduce its balance sheet by not buying new short-term Treasuries when the old ones mature. With long-term Treasuries, by contrast, the Fed must sell many of them on secondary markets. This could drive prices down, disrupting credit markets and causing losses for the Fed on its portfolio.

But the Fed no longer has to rely on dumping assets to impose monetary restraint. It can use four other methods to accomplish the same goal. These comprise either completely new tools or older tools that were previously of minor importance.

They are:

1. Loans to the Fed from the U.S. Treasury.

2. Reverse repurchase agreements (reverse repos)-that is, borrowing by the Fed. The Fed sells a security from its portfolio with an agreement to buy it back. Under new Fed chairman Janet Yellen, the Fed uses this device extensively, borrowing over $200 billion.

3. Term Deposit Facility, a mechanism through which banks can convert their reserves deposited at the Fed (which are just like Fed-provided, interest-earning checking accounts for banks) into deposits of fixed maturity at higher interest rates set by auction (making them just like Fed-provided certificates of deposit for banks). Fed officials have made clear their intention to employ the Term Deposit Facility liberally if necessary. This would drain bank reserves by converting bank deposits at the Fed from implicit loans to explicit, higher-interest-earning loans with fixed maturities.

4. Interest on reserves. The most important way the Fed began borrowing and continues to do so is by paying interest to banks on their reserves. Permission to do so was included in the Troubled Asset Relief Program (TARP) Act, and the Fed started using that power within days. Interest-earning reserves have encouraged banks to raise their reserve ratios rather than expand loans to the private sector. This tool thus constitutes a flexible substitute for reserve requirements.

The rate that the Fed pays on reserves started out as high as 1.4 percent on required reserves and 1 percent on excess reserves, but it is now fairly low on both: 0.25 percent. Yet the alternatives available to the banks are little better, especially after adjusting for risk. It is the gap between these rates that determines the incentive for individual banks to hold reserves. The interest on three-month Treasury bills remains lower, and both T-bills and reserves are assets that impose no legally mandated capital requirements on banks.

By paying interest on reserves, the Fed has made itself the preferred destination for much bank lending. Should market interest rates begin to increase, raising the prospect of increased bank lending and inflation, the Fed can increase the interest rate it pays, locking up bank reserves and keeping reserve ratios high.

These four tools combined make it possible for the Fed to prevent any expansion of the broader monetary measures without selling off any assets. Of course, the Fed may supplement these tools with some asset sales, but sales are unlikely to be large initially. Interest on reserves will almost certainly be the dominant exit tool.

Treasury deposits may not become significant again, given the national government's huge deficits. Use of reverse repos could be somewhat constrained by Fed concerns about the solvency of the counterparties it borrows from, whereas this is not a serious consideration for highly regulated and monitored commercial banks. Term deposits are just a modified way of paying interest to banks.

Another issue that could affect the exact mix is how these tools affect Fed income. Treasury deposits are the only exit tool that cannot reduce Fed earnings. The Fed pays no interest on Treasury deposits directly, so the Treasury would bear the cost of rising market interest rates if it engaged in extra borrowing on behalf of the Fed. This would be offset only partly by the Fed's regular remittances of its excess earnings to the Treasury. On the other hand, paying higher interest on reserves, on reverse repos, and on term deposits would all directly curtail Fed earnings, whereas any large sale of assets could impose capital losses.

Rep. John Campbell, a California Republican who heads the monetary policy and trade subcommittee of the House Financial Services Committee, has warned that central bank losses are "a legitimate concern and something we will be watching." It would be truly ironic if congressional and popular hostility to the Fed pressured the Fed to create more money to keep Treasury remittances flowing, possibly contributing to the very inflation that so many Fed critics fear. And if the Fed's exit strategy coincides with a Treasury fiscal crisis, all bets are off. That last scenario, though, would arise, not from Fed monetary policy per se, but from Congress' and the president's deficits and debt.

My analysis is not advocacy. I do not claim that it is good for the Fed to have these powers. Indeed, as I argued in a presentation at the San Francisco Federal Reserve Bank in April, I would like the Fed to have zero power. The Federal Reserve's sorry century-long record is evidence for its failure. But the issue at hand is whether the Fed's actions will produce high inflation. That is highly unlikely.