Can the recent injections of liquidity by central banks increase inflation in the near term?

Question

Too much easy money is what led to skyrocketing house prices and the current financial troubles in the economy. And this makes me wonder if the huge loans central banks gave to private banks in the last couple of days are only going to prolong this situation and perhaps make it worse in the long run?

Private banks will hide their bad loans for a while longer and perhaps even lend some more to people who can't pay. But in the end they'll have to come clean anyway?

Answer 1

You are certainly more knowledgable than most people about the problem. Yes. The Fed created the problem and they will do everything they can to see if they can mitigate their previous screw up. They will probably just make things worse in the long run.

Answer 2

Yes, but the asset bubbles are because of the excess liquidity. There is a wonderful example that was well documented during the 1830's by Peter Temin of just this phenomena. An increase in the money supply should trigger inflation, but does not always do so. Instead, sometimes money moves into the asset markets. During the 1830's a large shift in the money supply occured due to a number of external and simultaneous factors. There was, if memory serves me, a 50% increase in the supply of specie almost instantaneously, though no one knew it at the time.

Prices did shift over a period of two to three years, but in the mean time purchases of raw land created a huge land bubble that suppressed inflation until the bubble ran out of steam and the cash was used to buy goods. So there are two alternatives, buy consumption goods or buy durable assets such as land or equipment.

So much land was bought in one year that it would have taken every man, woman and child an estimated 230 days to clear it all. Of course, once everyone realized this, the land was nearly worthless again.

The central banks are injecting liquidity into the system to prevent it freezing up. Bank overnight rates spiked 1/2% on Wednesday, the biweekly clearing date required by the Fed. Banks refused to loan one another overnight funds, regardless of collateral. These excess reserves are not interest bearing. Holding onto them guarantees a bank a lower income.

The central banks are trying to cheapen the opportunity cost of money by forcing banks to cooperate. It will likely trigger persistent increases in inflation if it is permitted to go on too long.

The central banks did in fact create this situation. The Clinton Administration raised taxes, reduced the size of government and started repaying the debt. They did it so quickly that they actually started reducing the money supply. The public debt is an important element of the supply of money. If you pay it back, you reduce M2. There were two effects of this. First, money was returned from inefficient government hands and put it back into the efficient hands of the capital markets. Second, in order to stabilize the effects on the money supply, the Fed decreased rates and increased available reserves. Of course, in practice this meant a ton of money went through Wall Street and we got a bubble.

W has reversed this situation with literally record borrowing. The only thing keeping that floating has been the PRC and now they are threatening to use that leverage. We are having a liquidity crisis because the US banking system maintains $42 billion in cash reserves, the PRC now has $1 trillion in cash reserves. If you wonder where all the liquidity has got, look East to the PRC. The PRC is much smaller than the US and even allowing for growth should probably only need 20-30 billion in cash reserves, given their inefficiencies. There is a big day of reconning about to happen.

Answer 3

The Central Banks released this money to quell fears of the money supply tightening as more and more people are moving to cash positions and out of equities and derivatives. The private banks will have to repay this money sometime. In the end the private banks and mortgage banks will take the hit on any sub-prime mortgages that are in default and any one who invested in this debt will take the hit too, just like Nova Star Financial (NFI).
The easy credit days are truly over but unless the absolute prices of products and services increase there will be limited inflation. The Fed is focusing more now on inflation than in the recent past, which to me is a good sign.
I am a believer in monetarist policy and that the Fed should leave things alone to reach their own equilibrium. Anyone who invested in Sub-prime debt did so at their own risk.

Answer 4

Yes it will create inflation, but the flip side of not injecting liquidity, is to start a DE-flationary spiral, which is extremely difficult for the government to fix, Japan is in one now, you just don't here about it.
Everything is dropping, employment, gdp, cpi, the only thing rising is land price, not housing, just land

Answer 5

In the near term, no.

In the context of a ten trillion dollar US economy, a few days of open market operations do not make an era of increasing inflation. The Fed has not actually allowed short-term rates to decline, and undertakes similar fine-tuning operations unobserved nearly every day. But, by announcing and timing the announcements in high-profile fashion, the Fed seeks to send a reassuring message that the Fed is closely monitoring the markets and will take necessary steps to avoid market disruption due to lack of liquidity.

The quantity theory of money is based on the accounting identity that the money supply times the velocity of money (number of times a dollar get spent) is equal to nominal transactions (price level times real transactions). Therefore, if real GDP and velocity remain constant, an increase in the money supply implies an increase in the price level.

Quantity theorists would argue that velocity is relatively stable and GDP fluctuates around potential GDP, and therefore an increase in the money supply inevitably leads to higher inflation, although with an unknown lag.

Others would argue that a money balance is a cash entry in a world of derivatives and off-balance sheet financing, and that the amount of cash money a corporation or individual has doesn't have a stable long-term relationship with the entity's transactions. With credit, an individual can have ample liquidity available for transactions without cash in the bank, and through swaps and derivatives, a corporation can show cash on the balance sheet when its financial position is illiquid.

In the Volcker era, the Fed briefly embraced monetarist dogma, increasing the money supply in line with relatively strict target ranges. The use of targets may have reflected the need to send a credible message that rates would rise as high as necessary to bring inflation down, more than a belief in stricter interpretations of quantity theory. As rates slowed the economy and crushed inflation, without always keeping money supply on a stable course, the targets were abandoned.

Despite abandonment of strict monetary targets, inflation continued to decline in the Greenspan era. The Fed adopted a more flexible, gradualistic (some would say ad-hoc finetuning) policy, but informally adhered to policies consistent with a Taylor rule: a formula that sets real short-term rates at a level that will bring inflation down over time, while reducing rates when actual GDP is below potential GDP, and increasing rates at full employment, in order to stabilize the economy.

The most commonly cited version of the Taylor rule is to set the Fed Funds rate = inflation rate + 2% + 1/2 ( GDP gap ) + 1/2 ( inflation rate less 2% ). Note that if inflation is 2% and GDP is at potential, the Fed sets overnight rates at inflation + 2% (neutral policy). As inflation rises above 2% or GDP rises above full employment the Fed hikes rates (tight policy). Conversely as inflation falls or GDP falls below full employment, the Fed cuts rates (easy policy).

According to the Taylor formula, current policy of 5.25% Fed Funds target is neutral to perhaps slightly restrictive. This policy followed a long period during which rates were at historical lows, despite large government deficits, enormous increases in dollars assets held by foreigners, especially central banks, and large price increases in many assets (real estate and stocks) and consumer products (energy, food, medical services, tuition), as well as a declining dollar.

In the future, there may come a time when rate cuts might be desirable due to domestic considerations, but would risk inflation and a drop in the dollar's FX rate. This would parallel the situation the US faced at the beginning of the 1970s, as well as past crises of other debtor nations in Asia and Latin America.

In many cases pressures to maintain economic growth, social programs, and military spending in the face of large foreign debts, declining currencies, and rising import prices, resulted in an era of rising inflation.

If the answer to every crisis is to print more money, in the long run the answer is yes, it will lead to more inflation.

Answer 6

right on lady you hit the nail on the head