Inflation vs. Deflation: The Quantity Theory of Money – M & V
I’m deliberately being simplistic and reducing the inflation/deflation debate to the monetarist framework; I think it’s useful as a starting point in order to get a grasp of the facts – and I like scary graphs. So take a look at the St. Louis Fed statistics regarding currency in circulation and monetary base: despite abundant talk of the Fed printing money, currency in circulation on an absolute level has not increased that drastically over the last few months. Sure, the slope of the curve or pace of increase has accelerated a lot, but from an absolute perspective things don’t look too bad:
Unfortunately, the above graph only shows currency in circulation, or the amount of currency available to consumers. The picture looks very different when you look at the US monetary base (i.e. Fed reserves and the reserves of commercial banks at the Fed): the monetary base has more than doubled over the course of 2008.
Hard to argue that this looks like it should spell inflation. Why haven’t we seen any of it so far? The answer is simple: banks have increased their excess reserves and are too scared of what may come to lend to the consumer. The graph below shows the missing link between monetary base expansion and the growth (or lack thereof) in the volume of currency in circulation, namely bank reserves in excess of Fed requirements.
The above charts suggest that we are currently seeing deflation concerns because banks are increasing their excess reserves faster than the Fed is expanding the monetary base; in other words, all the additional money printed by the Fed is getting soaked up by banks and the consumer is seeing decelerating inflation. This trend is bound to reverse suddenly and drastically once credit thaws, though. At that point do you think the Fed will be able to drain excess cash from the system fast enough to prevent massive inflation?