Central Bank Money Without Inflation?

Except for places like Argentina, Venezuela and Sudan, inflation is remarkably low. In fact, virtually no advanced economy in the world has inflation that is even 5%. In the euro area, the harmonized index of consumer prices is rising at roughly 0.7%. And, in the United States, the consumer price index rose by 1.1% over the past 12 months.

Having been taught that inflation is a monetary phenomenon, and looking at the explosion of central bank balance sheets, people are rightly confused. How can the ECB’s balance sheet virtually double from €1.2 trillion in mid-2007 to €2.2 trillion over nearly 7 years when prices went up only by 12.2%?  Even more striking: over the same period, the Fed’s balance sheet went from $868 billion to nearly $4.3 trillion as prices rose by 13.3%. At a compound annual rate, that’s average balance sheet growth of nearly 25% versus a price rise of around 2%.

Shouldn’t all this central bank money be causing inflation?  Under normal circumstances, the answer would be yes. But the last seven years have not been normal. To see this, all we have to do is look at a broad measure of money – say, M2 for the United States and M3 for the euro area. (They have somewhat different conventions for measurement, but are reasonably comparable.) Well, there we see that things look a bit more reasonable:  U.S. annual M2 growth has averaged roughly 6½%, while euro-area M3 growth has been around 2¾%.

Normally what happens is that the central bank provides reserves to the banking system, and the banks lend it out. In recent years, however, banks have not been lending much. To see this, just look at the extent to which banks are holding excess reserves. In the United States, reserves plus cash are now 26.6% of bank assets. In mid-2007, the equivalent number was only 3.4%!

The big question has been: Why aren’t banks lending? Is it because their standards are too high or because people aren’t coming in to ask for loans? During the crisis and shortly thereafter, supply probably mattered greatly, and it probably still matters in much of the euro area. By now, however, we suspect that the limiting factor in the United States is mostly demand.

Regardless of whether you think we’re right – whether it is U.S. borrowers not wanting to borrow (our view) or U.S. lenders not wanting to lend (the view of some others) – the thing to watch will be whether U.S. banks start to lend. That is, look for increases in credit. When you see a sustained pickup, unless the central bank starts to raise interest rates to tighten monetary policy, inflation will not be far behind. With inflation currently well below the Fed’s 2% long-term objective (for the price index of personal consumption expenditures), a modest pickup is what the Fed hopes to achieve.