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Slaughter & Rees Report - The “Silver Blaze” Search for Inflation

April 22, 2013 --

Twice a year, the International Monetary Fund and the World Bank convene meetings in Washington to discuss current issues facing the global economy. The spring meetings occurred last week, and one of the important questions addressed was, “Where is inflation in the world today amidst all the world’s monetary stimulus?”

Good question. Since the global financial crisis started nearly six years ago, the world’s central banks have expanded their balance sheets by about $12 trillion collectively. To do this, they did not literally print $12 trillion in new currency notes. Rather, each central bank mostly expanded its supply of the other main part of “high-powered money” or “monetary base”—the reserve deposits private banks keep with central banks (either by mandate or by choice).

Consider the Federal Reserve, which each week publishes its balance sheet online. Just as the first tremors of the financial crisis were being felt during the second week of August in 2007 when BNP Paribas froze three of its funds, the Fed’s balance sheet stood at $869.3 billion, of which $13.5 billion was reserves held by “depository institutions”—i.e., financial institutions that are members of the Federal Reserve system with which it transacts assets to expand or contract the supply of high-powered money. What about last week? The Fed’s balance sheet stood at $3.23 trillion, with reserve deposits held by member institutions at $1.85 trillion. Yes, you read that right: this critical part of America’s high-powered money has expanded by a factor of more than 100.

Why, then, has this gazillion-percent increase in the U.S. supply of high-powered money not unleashed price inflation of a gazillion percent? The proximate explanation is that banks, from which the Fed has been buying assets paid for with reserve deposits created out of thin air, have not been lending these reserves to businesses and households. Historically, these loans increase broader measures of the U.S. money supply that, in turn, tend over time to raise the prices of goods and services. The deeper explanation for the absence of inflation is the financial crisis: broken, scared, and/or healing banks have been reluctant to lend as they traditionally did. In finance jargon, the “money multiplier” is broken.

So what impact has the world’s massive increase in high-powered money had? It has supported some growth in real output, albeit less than many had hoped. It also seems to have supported asset prices, granted in ways that central banks and investors do not fully understand. Indeed, in the post-crisis world, policymakers are striving to better understand how money shapes asset prices—and whether and how asset prices should influence monetary-policy decisions.

So the search for inflation goes on. In the latest installment of its semiannual publication World Economic Outlook, released last week, the IMF has penned an interesting chapter on inflation. The chapter opens by quoting Sherlock Holmes famously noting “the curious incident of the dog in the nighttime” that did not bark when prize racehorse Silver Blaze was stolen. Building from this observation, Holmes managed both to find Silver Blaze and to explain the mysterious death of its trainer (note: do not try to win a sly wager by nicking your horse’s leg tendons with a small blade, lest you want a hoof to the head). To similarly solve the mystery of the inflation that didn’t bark, central bankers may need all the observational acuity of Sherlock Holmes himself.

Articles © 2013 Matthew Slaughter and Matthew Rees. All rights reserved.
Publication © 2013 Trustees of Dartmouth College. All rights reserved.

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