Not so long ago, during the age of Milton Friedman, the chief concern of monetary policy was inflation. The Federal Reserve’s job was seen as a balancing act: Too low a money supply would slow spending, and too much would erode purchasing power. Of course, given the inoculation of monetary economists against anything resembling deflation, we really only worried about erring in the other direction. Good monetary policy meant open-market operations to keep the money supply on a predictable path, which gives markets a stable foundation for short-term and long-term contracting, facilitating economic coordination.
But the inflation-as-bogeyman era is gone now. Beginning with the 2008 financial crisis, operational changes at the Fed broke the link between the size of the central bank’s balance sheet and the purchasing power of money. The Fed’s assets grew from under $1 trillion in mid- to late 2008 to $4.5 trillion in early 2015, and then to $7.4 trillion today. You’d expect the massive increase in the monetary base to create inflation. But you’d be wrong. Why? Because beginning in late 2008, reserves held by depository institutions at the Fed skyrocketed. During the COVID-19 crisis, they climbed still higher. The bottom line: All the newly created money in the world won’t drive up prices if it doesn’t circulate through the economy. Right now, it isn’t.
The reason for inflation’s disappearance is the Fed’s switch from a corridor system to a floor system. Once the Fed started paying interest on excess reserves in October 2008, banks had little incentive to turn the massive amounts of newly created liquidity into loans. This was intentional. The theory of then-Chairman Bernanke’s Fed was that the ongoing crisis was propagated by a deterioration in the balance sheets of major financial institutions. The point was to take bad assets off their books (swap them for cash) in a way that wouldn’t generate inflation. The plan worked, up to a point. The financial system didn’t collapse, and prices didn’t shoot up.
But the floor system isn’t a free lunch. By focusing too much on firm-level balance sheets and not enough on broader monetary aggregates, Bernanke’s Fed inadvertently held back the recovery. Lost output and employment during post-2008 are only partly to blame on President Obama’s misguided economic agenda. Reckless innovation in monetary policy mattered even more.
More than a decade after the enactment of the floor system, economists are starting to notice other insidious features. In some ways, the lack of inflation makes it harder to discipline the Fed. Price increases are a visible phenomenon, felt by millions of Americans. Though technocrats like to pretend otherwise, central banking is political, and in politics visible results matter a lot more than invisible results. Inflation is salient. What’s going on right now isn’t, but that doesn’t make it any less dangerous.
Charles Plosser, former president of the Philadelphia Fed, is worried by what he sees. And rightly so. The Fed’s floor system is much more vulnerable to political interference than the old corridor system. “The adoption of unconventional monetary policy that sought to expand the reach and effectiveness of the Fed’s tools in order to influence and shape real economic outcomes sometimes broke the traditional boundaries that separated monetary from fiscal policy,” Plosser writes. “One predictable consequence is increased political pressure on the Fed. Indeed, such actions amount to an open invitation to such pressure.”
It’s precisely the lack of inflation from monetary expansions that makes this the case. The Fed’s balance sheet has lost its limiting factor: A “key element” of the floor system is that “the Fed’s balance sheet is no longer tied to monetary policy.” Plosser continues, “The primary instrument of monetary policy in a floor system is an administered rate, the interest paid on reserves (both excess and required). The balance sheet or the volume of reserves is not crucial to the setting of monetary policy as long as demand is satiated at the interest rate paid on reserves.”
The Fed is constrained by both political and economic realities when setting interest on reserves, but it still has plenty of room to maneuver. Policymakers enjoy having the wiggle room to tinker, but it rarely benefits anyone else. Plosser gets at the heart of what’s wrong with the floor system when he writes:
Once the demand for reserves is satiated, there is no limit, in principle, to how big the balance sheet or volume of reserves can be. A large balance sheet unconstrained by monetary policy is ripe for abuse. Congress and an administration would be tempted to look to the balance sheet for their own purposes, including credit policy and off‐budget fiscal policy.
And there we have it: Fed policy has crossed the fiscal-monetary Rubicon. Our central bank is conducting fiscal policy masquerading as monetary policy. As long as the Fed keeps paying interest on reserves, its balance sheet can (and has) become immense without inflationary consequences. This means the Fed now has much greater power to allocate real (inflation-adjusted) purchasing power.
It’s bad enough that the Fed can pick winners and losers with impunity. But it’s even worse if Congress gets involved, and there’s every reason to think it will. If you’re a legislator and you want to pay for a pet program without raising taxes, the Fed’s balance sheet is a tempting funding pool.
To repeat a phrase I often used, funny money is out and crony credit is in. Inflation isn’t the biggest concern right now. The politicization of money and credit is. Too many in the financial commentariat are looking for the devil we know in the form of runaway price increases. But the consequences of yesteryear’s bad monetary policy are of little immediate relevance.
We’ve got much bigger problems than rising consumer-goods prices. Somehow, we’ve got to get control over the Fed’s preferential credit allocation.