The Federal Reserve—the Fed—is the only institution in our economy that is authorized to create money, essentially out of thin air. This can take the form of cash, those greenbacks in your wallet, or electronic credits to bank accounts. Since early March, the Fed has ramped up liquidity roughly $2-1/2 trillion—yes, trillion. This has been done mainly by purchasing Treasury securities or making loans to a growing array of borrowers, and they have done this by crediting bank accounts. As a result, can we avoid inflation from too much money chasing too few goods?

In ordinary times, the Fed makes loans to commercial banks—in relatively small amounts—and occasionally purchases Treasury securities. However, over recent weeks, the Fed bought roughly $2 trillion of securities and lent nearly $100 billion to parties other than banks—securities dealers, money market funds, and businesses. Beyond these, the Fed provided over $400 billion of liquidity to other central banks (collateralized by a similar amount of their local currency). Moreover, the Fed has indicated clearly that it is not close to stopping.

The Fed will not be exposed to losses on these loans, because a portion of the $2.2 trillion in the CARES Act is earmarked for reimbursing the Fed for losses on these credits.

But that leaves the question of whether we are going to pay for this massive liquidity injection by a surge in inflation. Too much money becomes an inflation problem when individuals, businesses, and banks do not want to hold it and exchange it for other things. To date, this has not happened. With so much uncertainty about prospects in the weeks and months ahead, individuals, businesses, and banks are hoarding this liquidity. And the Fed has been aggressively acting to make sure that they have all the liquidity they want. A similar situation occurred in 2008 and 2009 when the Fed responded in an unprecedented, but more limited, fashion. Concerns were raised at that time that we were about to experience massive inflation. In the event, inflation was quiescent. The Fed navigated the exit from a potentially explosive situation skillfully.

Whether we escape the inflationary consequences of an even more massive injection of liquidity will again depend on whether the Fed knows when to remove the punch bowl…ending the party.

That won’t be anytime soon.

2 thoughts on “Are We Drowning in Fed Liquidity?

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s