A few weeks ago I addressed the question, “Who Wants Sound Money?” Because my answer was that apparently everyone does, the next obvious question is: who should be responsible for assuring sound money?
In the case of the US dollar, the original answer at the time of the founding of the country was the US Congress, and the dollar was defined as a weight of precious metal. During a decades long experience with specie-backed money, there was significant meaning attached to the expression, “Sound As a Dollar.” However, after the highly inflationary decades of the 1960s and 1970s, that expression lost much of its meaning and fell into disuse.
A few decades ago, Congress assigned the responsibility for determining the purchasing power of the dollar to the Federal Reserve System–at the same time charging the central bank with simultaneously maintaining a low rate of unemployment. About a decade ago the US monetary authorities started announcing that their objective was to erode the purchasing power of the dollar at about 2 percent per year on average. Fortunately for the holders of money around the world, the managers of the US currency have fallen short of their objective.
For the past several years, the central bank’s preferred measure of inflation, the personal consumption expenditures deflator, has persistently risen at an average rate below the announced target of 2%, causing writers in the financial press to frequently report the “disappointing” slow rate of inflation. One might wonder, if more inflation is desired by the people in charge of creating money, what is so difficult about “printing” more dollars and generating greater inflation?
Well, it turns out that the US central bank no longer has any control over the amount of dollars being used by people around the world–which is what my previous posting was leading up to. It has long been the case that the amount of US currency in circulation–currently about $1.4 trillion–is simply whatever amount people around the world want to hold. In the words of economics, the supply is determined by the demand. That is, there can be neither an excess supply of nor an excess demand for Federal Reserve supplied dollars.
While that has been true for Federal Reserve Notes–paper dollars–for the century of their existence, the same was not true of dollar deposits–until recently. Previously, the amount of dollar deposits held at banking companies was constrained by the aggregate amount of bank reserves created by the monetary authorities. The banking system–but not an individual bank–was “reserve constrained.” If the public wanted to hold more currency, bank reserves would fall causing a multiple contraction of dollar deposits–unless the central bank created more reserves. The monetary authorities could, if they chose, decide how much money was in circulation.
That all changed a few years ago; in 2008 the Federal Reserve Banks started paying interest on reserve balances held idle by commercial banks (IOR) and subsequently the policymakers engaged in “large scale asset purchases” (LSAP), commonly know as “quantitative easing.” Today, banking companies operating in the U.S. hold over $2.5 trillion of “excess” reserve balances at Federal Reserve Banks. The result has been that the commercial banking system is no longer “reserve constrained.” Monetary policymakers do not affect the amount of deposit money by adding to or reducing reserves available to the banking system.
Since the central bank no longer controls the amount of money–dollars–being held by individuals and businesses around the world, how do they influence the purchasing power of dollars, inflation, over time? The short answer is, they don’t. As I conclude in a paper for the annual Cato Monetary Conference in a few weeks, not only has the central bank been unable to create the higher rate of inflation they claim to want, they also will be powerless to prevent any acceleration of inflation that may arise as a result of forces outside their control.