Bank Reserves and Inflation

Per Fed data, nearly $1T has been added to base money in the last 4 months. If all of it were lent out by recipient banks, it could expand upwards of $10T (at 10% fractional reserve), nearly doubling the overall money supply. But as we know, banks have hardly been lending their bailout money… thankfully, because it was excessive credit that got us in to this mess.

During the period of base money expansion, starting last September, prices have remained at best the same for most common everyday goods, and have been dropping for things like gas, houses, and most investments. Even retail prices have been dropping with more and more on-sale items to be found. The money added to bank reserves almost exactly matches the base money expansion. So the question becomes, how inflationary would be increasing bank reserves if the reserves are just sitting there?

Let’s start by examining the deflationary forces that prompted recent increases in base money. Say a $500,000 house in the outskirts of Stockton two years ago now goes for $200,000. That’s a decline in wealth by $300,000. Now, as much as people who hold legal title to the house like to believe they are homeowners, the truth is, until the mortgage is paid off, it is owned by the bank—and in this situation, one does well to take full advantage of that and mail the bank their keys if there were little equity in the place. The bank will recover what it can, about $200k at auction, and be stuck with a $300k deficit, minus any equity there might have been.

Now the original $500k loan added to the money supply via fractional reserve credit is still out in circulation (sitting in the sellers bank account unless they spent it, in which case the money is wherever it is in a line of transactions). If the Fed or Treasury department decides to keep the troubled bank afloat and grants them $300k in base money for their loss, is that $300k worth of money expansion? The rescue of the loan can be viewed as a deposit of new currency from the Fed. Which is inflationary.

But what price increases there were during a credit happy environment are now stressed with credit contraction, and not sufficiently compensated by base money expansion. So while inflationists are right that we have a lot of inflation in base money, we have greater contractions in credit, and general price declines.

Whether inflationary forces outweigh deflationary ones, or vice versa, the proof is in the pricing: the dollar now buys more houses, gas, stocks, and a slew of retail items than it once did. There is a broad contraction of investment wealth, and only the banks (and AIG and automakers) are being rescued. Deflationary forces are prevailing over inflationary ones, and I see no reason to anticipate a quick turnaround.

If this deflationary course reverses I’ll be the first to report on it.