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Today the Federal Reserve released its weekly balance sheet:

The liability side of the balance  sheet comprises the monetary base, which is currency and deposits held in reserve by various entities with Federal Reserve banking system.  

Today's balance sheet shows an increase of $372 billion in Fed liabilities since October 3, 2007, when they totalled $902 billion.  Now they total $1,361 billion, representing a huge, unprecedented increase of 41 percent.  The increase since just last week alone, September 24, is $191 billion.  

Technically, the Fed is expanding the monetary base, at least temporarily.  However, it is not yet formally monetizing the debt to be created by the bailout plan, and whether the massive increase in the monetary base will become inflationary depends on a number of factors, and especially on how the Treasury acts with respect to the bailout and on further moves by both it and the Fed more generally with respect to fiscal and monetary policy.

  1. The Treasury has sold 150 billion of new bonds already, but it has placed the proceeds in the Fed, which is a liability of the Fed on its balance sheet. The Fed can then use that money to buy bonds, because it has been selling a huge chunk of them, and needs to replenish its holdings of Treasury securities. Doing it this way prevents the purchases of bonds by the Fed having an inflationary effect, since the original sale by the Treasury first drained money from the banking system, and given that the Treasury is not spending that $150 billion on other things.
  1. The propsed bailout would also require the Treasury to sell 700 billion in new bonds. The $630 billion of new dollar liquidity recently arranged by the Fed in consort with foreign central banks will or can be used by those foreign monetary authorities to buy those bonds, or to lend to other foreign entities who wish to buy them. Again, this is not technically inflationary, because these are loans and need to be repaid, not permanent injections of new money, and because the increase in dollars would essentially be converted to an increase in Treasury bonds, keeping the money out of the banking system, and because most of the increased supply of dollar liquidity would take place abroad rather than in the US domestic economy.  

However, when the Treasury starts using the money raised to buy subprime debt from the firms in trouble, the money will start circulating here.  If the plan works, of course, the Treasury will get all or most of that money back when it eventually sells the subprime assets, and it can then be withdrawn from circulation.  But right now, I'd say that's a rather uncertain proposition.  So the potential risk for inflation further down the road is considerable, in my view, since once this extra liquidity is out there, it will not be easy to reduce it without causing another credit crunch and set of insolvencies in the financial sector.  So the Fed may well extend the loans practically indefinitely.

So, in sum, this big expansion of the Fed's balance sheet probably will, to a significant extent, end up adding to the permanent money stock. At the same time, if financial intermediaries such as banks and other lenders fear recession, and they do, then they will hoard cash or its equivalent (i.e. Treasury bills) and not use it invest in the real economy. I.e., we will be in a liquidity trap.

In a word, all the signs point to stagflation.

Originally posted to stunster on Thu Oct 02, 2008 at 03:25 PM PDT.

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