In our earlier lengthy post about the inflationary dangers arising from the Federal Reserve’s mortgage securities purchase program, several of our readers thought we were confusing growth of the monetary base with growth of the money supply.
Let’s make this very simple.
Under the Fed’s traditional strategies to ease a liquidity crunch—lending from the discount window, increase repo auctions—the Fed increases the monetary base. This means that the reserves at banks increase—as the chart to the left shows. But it doesn’t mean that the supply of money in the broader economy increases.
If banks start to lend out money and bring down the reserves, the Fed can increase the cost of its overnight lending to banks or halt other lending programs to rapidly reduce the reserves and slow lending. Essentially, the Fed has a call option on the dollars it has put into the system. When inflation heats up, it exercises the option.
But this program doesn’t work for the liquidity injected into the system via the purchase of mortgage backed securities. Here the Fed has no call option. It must sell the securities at whatever the market will bear. We think it is unlikely that it can pull in a dollar for ever dollar it spent—meaning we think the Fed will lose money on its mortgage backed securities—and this inability to recall some of those dollars necessarily has an inflationary effect. When you add in the multiplier effect that extra dollars in the banking system creates, you have a recipe for serious inflation.
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