NEW YORK - Although monetary theory suggests otherwise, inflation has remained tame and is expected to stay low for the next decade despite the "huge increase in the monetary base," Federal Reserve Bank of San Francisco President and CEO John C. Williams said Monday.
"Of course, if the economy improved markedly, inflationary pressures could build," Williams told the Western Economic Association International, according to prepared text released by the Fed. If the economy improves, he continued, "the Federal Reserve would need to remove monetary accommodation to keep the economy from overheating and excessive inflation from emerging" by either "raising the interest rate paid on reserves along with the target federal funds rate" or "by reducing its holdings of longer-term securities, which would reverse the effects of the asset purchase programs on interest rates."
Planning an exit will be the same as in past recoveries, he said. "Of course, getting the timing just right to engineer a soft landing with low inflation is always difficult. This time, it will be especially challenging, given the extraordinary depth and duration of the recession and recovery." But Williams is confident the Fed "is prepared to meet this challenge when that time comes."
Williams said the amount of currency in the system is not the concern. "For monetary policy, the relevant metric is bank reserves."
If the economy were performing better, banks would lend excess reserves. "Too much 'money' would chase too few goods, leading to higher inflation." But despite Fed tripling the monetary base in the past four years, the money stock hasn't ballooned and there have been no big jumps in spending and inflation.
Williams explained banks prefer holding reserves safely at the Fed rather than "lending them out in a struggling economy loaded with risk. The opportunity cost of holding reserves is low, while the risks in lending or investing in other assets seem high. Thus, at near-zero rates, demand for reserves can be extremely elastic."
Households also look at the "weak economy and heightened uncertainty," and "are hoarding cash instead of spending it," causing a breakdown in "the money multiplier," Williams said.
"The important point is that the additional stimulus to the economy from our asset purchases is primarily a result of lower interest rates, rather than a textbook process of reserve creation, leading to an increased money supply," he said. "It is through its effects on interest rates and other financial conditions that monetary policy affects the economy.
"But, once the economy improves sufficiently, won't banks start lending more actively, causing the historical money multiplier to reassert itself? And can't the resulting huge increase in the money supply overheat the economy, leading to higher inflation? The answer to these questions is no," Williams suggested "and the reason is a profound, but largely unappreciated change in the inner workings of monetary policy."
With the Fed paying interest on reserves, "the opportunity cost of holding reserves is now the difference between the federal funds rate and the interest rate on reserves. The Fed will likely raise the interest rate on reserves as it raises the target federal funds rate. Therefore, for banks, reserves at the Fed are close substitutes for Treasury bills in terms of return and safety. A Fed exchange of bank reserves that pay interest for a T-bill that carries a very similar interest rate has virtually no effect on the economy. Instead, what matters for the economy is the level of interest rates, which are affected by monetary policy.
"This means that the historical relationships between the amount of reserves, the money supply, and the economy are unlikely to hold in the future. If banks are happy to hold excess reserves as an interest-bearing asset, then the marginal money multiplier on those reserves can be close to zero. As a result, in a world where the Fed pays interest on bank reserves, traditional theories that tell of a mechanical link between reserves, money supply, and, ultimately, inflation are no longer valid. n particular, the world changes if the Fed is willing to pay a high enough interest rate on reserves. In that case, the quantity of reserves held by U.S. banks could be extremely large and have only small effects on, say, the money stock, bank lending, or inflation."
