We are living in an illusion that the relationship between nominal GDP and the amount of currency in circulation is dead. The illusion began in 2008, when the Federal Reserve began expanding the value of its assets without expanding the value of the currency in circulation. Instead, banks were paid to keep these newly created funds in the Federal Reserve account. The newly created money, thus, did not cause inflation despite the expectation among many that high inflation was imminent.
In the long run, inflation is determined by the rate of expansion of the prevailing currency and the increase in actual productivity. Increased real productivity tends to be inflationary, but moderate and relatively stable. Thus, the growth rate of a circulating currency is related to the growth rate of total expenditure, as well as to inflation.
After the 2008 financial crisis, the inflation rate was close to 1.7 percent. From the end of that crisis until recently, the pace of the currency has been declining, reflecting the fall in long-term nominal interest rates. Figure 1 shows the relationship between the velocity of the currency (right axis) and the nominal interest rate paid to the 30-year US Treasury (left axis).
It is true that an increase in the amount of money will support a proportional increase in the level of spending, as long as the movement of the currency remains stable. A more sophisticated expression of this fact is that the velocity of the currency is stable in the case of interest rates. Over the past few decades, currency movements have followed a downward trend in interest rates. Although the relationship was not 1-to-1, the expansion of currency stocks positively affected the overall spending level and price level. For most of this period, the currency of circulating currencies grew at a rate of about 7 percent where the nominal GDP growth rate was often between 3 percent and 5 percent.
According to this argument, the FOMC has responded to rising inflationary pressures by slowing the growth rate of the currency in circulation as nominal GDP levels have broken above the pre-2020 trend. Of these, however, the balance sheet continues to expand in the first quarter of 2022. The recent relationship between balance sheet expansion and annual inflation has led many to believe that the Fed’s current position is too simple. The balance sheet has grown for most of the previous decade without causing significant inflation. The issuing currency acts as a reserve that supports lending within the financial system. Policymakers and monetary policy regulatory protocols – for example, the Overnight Reverse Repurchase Agreement facility – have supported currency level stability in circulation. Stability in the way of NGDP reflects stability in the way of currency circulation. Not coincidentally, similar jumps have been made in NGDP and CPI since the currency jumped in circulation starting in the first quarter of 2020 (the vertical line indicates the beginning of the first quarter of 2020). Those who want to predict the future path of nominal GDP and price levels should focus on the circulation currency, not the size of the balance sheet.
Inflation, balance sheet expansion, and Fed solvency
Demands for linking inflation to the size of the balance sheet may, in part, stem from Fed officials’ focus on the size of the balance sheet in recent months. Recent statements by Fed officials reflect that high inflation readings have made policymakers increasingly concerned about the size of the balance sheet.
The sovereignty crisis is missing, however, as a larger balance sheet is more likely to be associated with lower interest rates and lower rates of real income growth. This balance sheet expansion program, called quantitative simplification, affects asset allocation by asset class and length of maturity. While some may expect that quantitative simplification stimulates overall demand, there is little empirical evidence or theory to suggest doing so. As the Federal Reserve begins to expand the excess balance sheet of the prevailing currency, real GDP growth has fallen to historic lows. For most of this period, the level of GDP was below its potential path. And with the Fed starting to reduce balance sheets in 2017, these declines were at a relatively high rate of real GDP growth. At the very least, it is unlikely that quantitative easing supports overall demand expansion.
Quantitative simplification certainly affects resource allocation. The Fed’s acquisition of subprime mortgages during the 2008 crisis reduced the risk of financial bankruptcy for companies leaving these mortgages. This was done to help stabilize a housing market that was in recession and the market climate seems to have contributed to the liquidity crisis. In addition to long-term US Treasury purchases, the policy was also intended to reduce interest rates at the top of the yield curve. The most significant effect of quantitative easing is the allocation of loans to special categories of borrowers.
Although balance sheet expansion has not caused inflation in the last decade, this does not mean that the Federal Reserve can expand the balance sheet without limits. Balance Sheet Extension Missing Circulation Currency expansion is not inflationary unless there is a discrepancy between the balance sheet’s assets and liabilities. Wealth income income. On the other hand, most of the liability aspect of the Fed’s balance sheet refers to the payment of income, which the Fed must do to maintain solvency. Until the revenue earned by the Federal Reserve exceeds the expenditure, the Fed remains solvent.
The expansion of the Federal Reserve’s balance sheet simultaneously increases interest-earning assets and liabilities, which require interest payments from the Fed. The Federal Reserve simultaneously borrows funds to curb inflation which it uses to pay for the assets it buys. For example, the Federal Reserve may credit an interest-bearing deposit to an account or borrow interest funds from the debt market overnight to offset the currency created by purchasing its assets.
Financial stability requires that interest payments from the Federal Reserve be made from receipts rather than money making. That means the Federal Reserve’s gains need to be positive. Positive profits, defined by income above operating expenses, are passed on to the U.S. Treasury. Negative profits must either be paid by the US Treasury or covered by the creation of new money. Negative gains will probably hurt investor confidence.
The asset side of the balance sheet should be limited to the liability side. Bankruptcy occurs when the value of liability is not offset by the value of the assets. Bankruptcy can occur, for example, due to rising interest rates. Suppose investors lose confidence in the Federal Reserve’s ability to maintain low and stable inflation. Rising mortgage rates will devalue the mortgage-backed securities already held by the Fed, which constitute a significant portion of the Fed’s assets. Thus, as interest rates rise, the Federal Reserve will probably have to start reducing the size of the balance sheet 1) to reduce losses on its balance sheet assets and 2) to reduce interest payments to institutions and investors as long as the Federal Reserve is solvent and investors expect it There will be solvent, a large balance sheet cannot automatically cause inflation.
At present, there seems to be little reason to doubt the Federal Reserve’s ability to contain solvents, as pigeons like Lel Brainard, who has recently been confirmed as vice chairman, have called for aggressive toughening.
Will inflation continue to rise?
As the rate of inflation rises year after year, many commentators have begun to think about the relationship between easy money and inflation. However, few of these commentators have consistently been correct in their assessment of Fed policy. For the most part, the Fed’s balance sheet does not differentiate between currency expansion and currency expansion. Over the past year, the year-on-year rate of inflation has continued to rise as a result of the increasing rate of currency exchange expansion organized by the Federal Reserve in 2020. The good news is that annual, monthly and quarterly inflation is more stable than last year. The Federal Reserve began controlling the currency’s expansion last year as nominal GDP returned to its pre-crisis trend. Nominal GDP has surpassed this trend, which is why we are experiencing a relatively high rate of inflation. But there is reason to expect that this overshoot is currently somewhere near its maximum level.
If inflation rises sharply and the rate of growth of the prevailing currency exceeds the rate of nominal expenditure, we should expect that inflation will decrease in the near future as the rate of currency expansion has moderated in circulation.
The rapid expansion of the currency, driven by the Federal Reserve, has helped boost spending as it plunged into the second quarter of 2020. Currency growth rates in circulation have returned to pre-crisis rates for at least 2 quarters. We should expect inflation and spending growth to follow and this will reduce inflationary winds.