05 November 2012

Monetary base (money supply) and inflation

We know that our nation is in massive debt, and the debt is accumulating fast. We also know that the FED has vastly expanded the monetary base since 2008.

Between 5-10 years, this should result in absolutely earth shattering inflation, as the correlation between monetary base and inflation is nearly perfect over a longer period of time.

The problem with this simple cause/effect prediction is that in 2008 the FED changed the rules. They now pay interest on Treasury bills, with the idea that they can buy up a bunch of bank debt without the banks immediately injecting the money into wider circulation, or something like that. It's called Quantitative Easing (QE). So, even though the monetary base has exploded, most of that money has not yet 'leaked' into the economy.  Greg Mankiw gives this as his reason why he doesn't think the massive increase in monetary base won't result, by itself, in inflation.

It's hard to know what the result of all these moves will be on inflation, but it does seem clear that QE1 and QE2, the first two rounds of quantitative easing, weren't as effective as it was first hoped. The FED response will be to just do some more of it!

So, mortgage rates will go down because of QE3, but who knows exactly when/if inflation will hit as a result of these measures?  The rules of the game have been changed.