(By Mani) Over the past four years, the U.S. monetary base has grown to more than $2.6 trillion from roughly $850 billion in the autumn of 2008, driven by implementation of quantitative easing as the Federal Open Market Committee (FOMC) endeavored to breathe life into the U.S. economy.
One question that we often came up is "Doesn't all this extra money sloshing around in the system diminish the value of the U.S. dollar and ultimately lead to higher inflation?"
Traditionally, inflation is related to money supply. But that is not happening as the surging monetary base have not created inflation.
"If prices were exclusively a function of the money supply, the near tripling of the monetary base between late 2008 and 2011 should have given way to runaway inflation, but that has not nearly been the case.," Wells Fargo economist Sam Bullard wrote in a note to clients.
Barring the run-up in gas prices and a few other commodities, price growth has been in check with the Consumer Price Index (CPI) averaging nearly 2.5 percent on a year-over-year basis for the past two years. This suggests that something else has to be at work.
When it comes to the impact of the growth of the money supply and the impact on prices, one major consideration is the money multiplier. If the banking system simply holds money in deposits on reserve and makes no loans, the banking system does not affect the money supply.
When banks make loans, however, the net affect is essentially an increase in the money supply. In a fractional-reserve banking system, banks create money through lending.
"With lending growth essentially stagnant, there was little impact on the money supply from the banking sector. More than anything else, it is for this reason that the traditional relationship between the money supply and inflation seemed to break down," Bullard added.
In addition to the monetary base and the reserve-deposit ratio, there is one additional factor to consider when thinking about the money supply: the cash-deposit ratio.
Essentially this is the cash in your wallet. To the extent that this money is not in a demand deposit account at a bank, it deprives the bank from the reserves that might otherwise be used to make loans and expand the money supply.
"We have little doubt that many savers in the past few years opted to put cash in a safe or just hold more currency than they might have otherwise. However, given the banks' hesitancy to make a lot of loans in this cycle, the currency-deposit ratio did not likely play a significant role in inhibiting growth in the money supply," the economist added.
Meanwhile, sluggish domestic demand combined with a substantial amount of economic slack does not create the conditions that would allow for headline inflation to accelerate at an elevated pace. Indeed, the Fed recently downgraded their inflation assessment at their latest FOMC policy meeting acknowledging that lower prices for crude oil and gasoline have helped contain inflation expectations.
With Europe still in recession and growth continuing to slow in China, commodity prices are likely to remain in check for the remainder of the year.
"As such, we expect the headline measures for import prices, PPI and CPI to continue to moderate on a year-over-year basis for the remainder of the year. Our forecast calls for CPI headline inflation to decelerate from the current 1.7 percent year-over-year pace to 1.2 percent by the end of the fourth quarter," Bullard said.
The economist also expects the headline personal consumption expenditure deflator to moderate to a 1.2 percent annual pace by the fourth quarter of 2012.
Core inflation, however, will likely remain elevated in the near term. Shelter costs, which represents more than 30 percent of the core CPI, have risen on a year-over-year basis over the past 18 months and currently stands at 2.3 percent. This strong underpinning from housing, as well as robust medical care services costs, are likely to prevent core inflation from declining as rapidly as headline inflation.
"We suspect that core CPI inflation will begin to trend lower in 2013 as the sluggish domestic demand outlook persists," Bullard added.