In 2008, when the U.S. Federal Reserve began to flood the world’s weakened credit markets with cash, many people worried that a catastrophic deterioration of the dollar’s buying power was imminent. Three years later, those dire predictions have yet to come true, and now there are rumors that the Fed may soon print still more money. So why hasn’t the dollar collapsed? And might the worst-case scenario still occur?
Before the recession, the Federal Reserve customarily held about $850 billion in Treasury securities. But by January 2012, this portfolio had swollen to nearly $1.6 trillion—and the Fed also owned another $838 billion in mortgage-backed debt and $103 billion in federal agency bonds.
The Fed acquired most of the additional holdings in its famous “quantitative easing” bond-buying campaigns of 2008-10 and 2010-11. The first round expanded the Fed’s internal balance sheet 150% from $924 billion to $2.3 trillion. The second added $600 billion more, for a total expansion of 215%.
This buying spree was financed in three ways. First, the Treasury Department issued several hundred billion dollars’ worth of new fixed-income securities directly to the Federal Reserve. Those bonds never openly traded and so didn’t swamp the Treasury market.
Second, the amount of money U.S. banks deposited with the Federal Reserve ballooned from near zero in 2008 to $1.5 trillion recently. Much as commercial banks use consumer deposits to fund ongoing activities, the Fed is using this mountain of capital—driven to it by a combination of a risky world and negligible interest rates—to finance its investment programs.
Finally, the amount of U.S. currency in circulation has expanded 20% since late 2008. This is the real “money printing” side of the Fed’s recent operations, and it could lead to serious inflationary pressure if Ben Bernanke and company fail to cut back when they feel the economy is healthy enough to thrive without support. So far, however, even with 20% more dollars chasing goods and services than there were in September 2008, consumer prices have climbed just 3.5% during the past three years.
Where’s the inflation? The answer lies in the distinction between the money supply and the money base, says independent economist Fritz Meyer. Think of the monetary base as the Fed’s balance sheet. “When you hear someone say the Fed is printing money, they’re referring to the monetary base,” Meyer explains. “The Fed has exploded the monetary base, for reasons related to the financial crisis.”
But the Fed’s balance sheet actually undercounts the number of dollars around the world. For an accurate reading, Meyer says, you need a wider gauge of money supply such as the “M2,” which includes money in U.S. checking, saving, and CD accounts.
On that basis, as you can see from the video, overall U.S. money supply expanded at roughly the same rate since 2008 as it had between 2005 and 2008: 23% to 25% over each three-year period. That “healthy” rate of expansion is good because it represents increased demand for dollars as well as increased supply, Meyer says.
“It’s good news for economic expansion down the road, even though it does bring the potential for higher inflation,” he notes. For now, Meyer is encouraged by “evidence that businesses and households are finally taking loans, which is the only way you create money,” he says. “That’s symptomatic of increased demand for goods and services.” And the current situation is substantially better than in 2008, when the global monetary system was on the verge of failure. Two months after the bankruptcy of Lehman Brothers, banks had stopped lending even to each other, instead hoarding cash for their own survival, and it took the Fed to get the wheels turning again.
Meyer is also skeptical that the most activist Federal Reserve in generations will let an increased supply of dollars get out of control. “I think the Federal Reserve will take back this monetary stimulus—which it can do very easily—when it believes the economy is truly out of the woods and inflation really is becoming a threat,” he says. “The question is, will it get the timing right?”
It’s a big question, but in the meantime, headline inflation has remained well below normal since the Fed started its printing presses. During the three-year period between 2002 and 2005, retail costs climbed a total of 9.5%, roughly in line with a 10% expansion of U.S. currency.
And while a third round of quantitative easing, this time focused again on the mortgage market, may be coming, it’s likely the Fed will keep as close an eye on its balance sheet as it has over the past three years.