Everything we were taught about the monetary base is wrong in a world with interest on reserves (IOR). A large base can sit there forever. The price level is not proportional to the base, changes in the base, etc. It just isn’t. The broader aggregates, such as M2, haven’t grown so rapidly.
But consider the scenario that worries me. Our debt continues to increase. Nominal interest rates rise, so the government has to borrow more just to finance the debt. Congress wants to avoid having to cut spending elsewhere, and the Fed is asked to do its part.
Tyler points out that the Fed could increase its purchases of Treasuries without increasing the money supply. However, the mechanism for doing this is to raise the interest rate that it pays on reserves. That mechanism does not solve the problem of lowering the government’s interest costs, which is what I think is the nub of the scenario that I am talking about.
My guess is that in practice, for a variety of reasons, when the cost of government debt starts to rise, the Fed is not going to be willing/able to sterilize its funding of the debt, through IOR or any other means. We are going to see both intended and unintended monetary expansion, and that will produce inflation.
As usual, let me say that I am not blaming the Fed or saying that inflation is just around the corner. When really out-of-control inflation emerges, it is a fiscal phenomenon.
What about raising the required reserve level? Wouldn’t that sterilize to insulate against inflationary pressures? To the extent the Fed is captured by the banks, this may not be a realistic option, but doesn’t it work in theory?
Raising reserve requirements also would push interest rates up.
I think monetary expansion is overrated and that velocity is the real driver of inflation, particularly in our modern economy where most transactions aren’t done with Fed notes, ie dollars. As such, increased reserves merely act as potentially more fuel for the fire, if and when the flames of velocity take off again, “potentially” because reserves don’t do anything unless printed and loaned out. Not much you can do to control velocity, other than stifling the economy overall with myriad regulations, as is being done now, but that’s a different issue. As long as Bernanke is in charge, I don’t see those reserves getting let out.
The key is who replaces him: it could be a two-step where Bernanke has taken a lot of risks but knows what he’s doing, only to be replaced by a dummy who’s handed those reins at the Fed and doesn’t know what he’s doing. If that happens, all bets are off.
“Nominal interest rates rise, so the government has to borrow more just to finance the debt”
Why will nominal rates rise without rising nominal growth?
g-r is same with or without inflation. If an argument about debt sustainability is to be made here, it won’t depend on ‘nominal’ vs ‘real’. It will hold for both.