How Would Fed Policy Lead to Inflation Without First Creating Jobs?

In discussing the Fed's recent to decision to reinvest the money it earns from mortgage backed securities back into long-term government debt the New York Times presented at length the views of Carl Walsh, an economics professor at the University of California, Santa Cruz. He warned that if banks suddenly withdrew the $1 trillion in reserves that they held at the Fed it could generate inflation.

While this is in principle possible, it would have been worth noting the mechanism through which inflation would be generated. The banks would have to lend out the money to firms who invest it, thereby increasing employment. This would lead to more jobs, higher wages, and then higher demand, which would allow firms to be able to raise prices.

This process takes time. The Fed would have ample opportunity to raise interest rates and slow growth before inflation got too high. Most people would probably be willing to take the risk that the economy might jump back to full employment too quickly.

credit flow
written by bakho, August 12, 2010 7:53

Prior to the housing bust, one of the primary channels for credit flow to consumers was the housing bubble with the bubble priced house used as collateral for borrowers. The bubble collapsed and so did the collateral base. For people underwater on a house, the risk premium for lending has skyrocketed. The Fed cannot lower the rates enough to cover the risk of the loans to people with underwater houses.

The only way to increase lending would be to lower the lending standards. That is what Greenspan allowed to happen during the housing bubble and the results were not good. We do not want to lower lending standards.

This means that the major channel for credit to flow from the Fed to consumers is blocked. Thus, any Fed monetary policy will have very little effect because the money is unable to flow. So it sits.

Too many economists are failing to add the blocked credit flows to their models. This makes them believe that the Fed can have more influence than they actually can.

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written by skeptonomist, August 12, 2010 8:39

The threat of inflation created by monetary policy is negligible in comparison to other current problems. Nevertheless, economists should keep past performance in mind when talking about the supposed ease with which the Fed could deal with it. In 1980 inflation was over 14% while federal funds was over 17% and in 1981 unemployment reached 10.8%. Somehow the worst period of inflation in American history is viewed as a triumph of the heroic Maestros.

There is a threat of inflation from government policy, and that is in some sort of upheaval in the Middle East which restricts oil supply.

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written by AndyfromTucson, August 12, 2010 9:04

So many people, including many economists, have lost sight of the fact that inflation is everywhere and always a spending phenomena, not a monetary phenomena. There was a period in the 20th century when the relationship between the money supply and spending was stable and this led many people to perceive a direct (and almost magical) relationship between the money supply and inflation. But has recent experience has shown that the relationship between the money supply and spending can change, which means everything that everyone "knows" about the money supply and inflation is worthless bunk. If someone predicts inflation without telling a story that involves someone (consumers, industry, or government) spending a lot more money now then you can safely ignore their predictions of inflation.

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written by izzatzo, August 12, 2010 9:24

What is economics if not scarcity

No trade offs around, just free goods abound
Like money that's funny and found

In federal reserves just sitting there
For stability and maintenance of sound

Scarcity principles that tick like a bomb
Once the money abounds

From a run on the fed that everyone dreads
Except the unemployed it rounds

Up with a vortex of stimulated scarcity
Which for now can nowhere be found

1980s inflation
written by bakho, August 12, 2010 10:00

1980s inflation had a significant oil shock component. Volcker gets all the credit. However, Carter's energy policy reduced oil consumption by over 20 percent and US oil consumption did not return to 1978 levels until 2000.

Conservatives prefer to give Volcker all the credit and Carter none of the credit.

Speculation
written by scott, August 12, 2010 8:26

Fed policy, giving 12.3 Trillion to banks to sit on when there is no borrowing, led them to play with commodities. Dr. Baker, must be cushy in your life, but local taxes are going up, services declining as are the cost of medical services, oil is currently overpriced relative to actual demand. Everything that matters is more expensive. That is all the stuff that economists exclude from the CPI it's a disgusting joke. Sadly, you professionals are so insulated you don't see it.

This is not the broad across the board inflation that actually helps raise all boats. It's rather driving wages down for those in the free market, whereas you are in the professional market--what is tuition doing Dr. Baker? Tuition, Insurance, utilities, food all are rising. So, should we be having a party because computer memory is cheap? Or that CRT TV's are dirt cheap? A delux TV was $700 now it's thousands.

What planet are you on?

caveat emptor
written by never believe economists, August 20, 2010 11:59

you obviously don't consider Argentina, Russia etc as being countries on this planet. they experienced hyperinflation without jobs.

guess what - America is about to as well.

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How Would Fed Policy Lead to Inflation Without First Creating Jobs?

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