Stagflation II: The Return

by Reihan Salam

We know that the Fed has made large purchases of Treasury bonds and mortgage-backed securities in the post-crisis years, and that the Fed’s balance sheet has increased substantially as a result. Yet inflation has remained very low by historical standards. Martin Feldstein offers an explanation for why Fed bond buying hasn’t boosted inflation by very much at all, and a hypothesis as to how we might return to “stagflation” in the near future.

When the Fed buys Treasury bonds or other assets like mortgage-backed securities, it creates “reserves” for the commercial banks, which the banks deposit at the Fed itself.

Commercial banks are required to hold reserves equal to a share of their checkable deposits. Since reserves in excess of the required amount did not earn any interest from the Fed before 2008, commercial banks had an incentive to lend to households and businesses until the resulting growth of deposits used up all of those excess reserves. …

An increase in bank loans allows households and businesses to increase their spending. That extra spending means a higher level of nominal GDP (output at market prices). Some of the increase in nominal GDP takes the form of higher real (inflation-adjusted) GDP, while the rest shows up as inflation. …

The link between Fed bond purchases and the subsequent growth of the money stock changed after 2008, because the Fed began to pay interest on excess reserves. The interest rate on these totally safe and liquid deposits induced the banks to maintain excess reserves at the Fed instead of lending and creating deposits to absorb the increased reserves, as they would have done before 2008. …

As a result, the volume of excess reserves held at the Fed increased dramatically from less than $2 billion in 2008 to $1.8 trillion now. But the new Fed policy of paying interest on excess reserves meant that this increased availability of excess reserves did not lead after 2008 to much faster deposit growth and a much larger stock of money.

The danger, according to Feldstein, is that as the economy recovers and as the demand for loans increases, commercial banks with enough capital will be able to meet this demand without worrying about inadequate reserves. This would fuel spending growth that could lead to an increase in inflation that could spiral, but the Fed could nip inflation in the bud by raising the interest rate on reserves. The question Feldstein raises is whether the Fed would be willing to do this if employment levels under this scenario remained disappointing. One can thus imagine inflation taking off while unemployment remains high, or stagflation redux. I take Feldstein’s basic point that low inflation at present doesn’t mean that inflation will never again reach excessive levels, but there are many, many things that would have to go wrong for this scenario to come to pass.