Since February 2020, the Federal Reserve has increased its balance sheet by nearly $3 trillion.  From its low in August 2019, it is approaching a doubling, or a 100% increase.

If you go back to 2008, the Fed’s balance sheet is now higher by a factor of almost 8 times. Over a 12-year period, this is incredible.  I can’t say that it’s unprecedented for a central bank, but it’s unprecedented for the U.S. central bank.

One thing that was a surprise after 2008 is that consumer price inflation did not run rampant after seeing such a big increase in monetary inflation.  I believe there are many contributing factors to this.

One is that the demand for dollars likely increased.  Or in other words, the money velocity fell, which meant money was changing hands less frequently.  Another major factor is that the U.S. dollar is still the world’s reserve currency.

I believe the biggest factor is that much of the new money went into excess reserves at the banks. A good chunk of the new money was not lent out by banks, thus not producing the multiplier effect from fractional reserve lending.

I will also point out that some would disagree that consumer price inflation has been low.  I agree that it may be understated, but I can also assure you that food prices did not go up by 4 or 5 times from 2008 to 2014.  Food prices are not 8 times higher today than in 2008.  It’s not even close.  Food prices are closer to the annual 2% or so price inflation as seen in the CPI.

Now, if you get into health insurance, that’s a different story.  But the dramatic increase in health insurance premiums has more to do than just monetary policy.

It is also true that while many consumer goods have seen low price inflation, it is a different story for assets.  Housing prices have risen in many areas beyond the rate of inflation as measured by the CPI. And then stocks are perhaps the biggest asset bubble of them all.

A big question now is whether we will see something similar to what was seen after 2008/ 2009. Will asset prices continue to rise?  Will the CPI remain relatively tame?  And where will all this new money go?

Excess Reserves

I checked the Fed’s graph on excess reserves held by depository institutions.  From February 2020 to May 2020, they went from $1.518 trillion to $3.217 trillion.  They increased by about $1.7 trillion in three short months.  Since then, reserves have fallen back to about $2.8 trillion, which is still an increase of almost $1.3 trillion from February.

The Fed’s chart says it has been discontinued this metric, but it appears up to date.  I’m not sure of the reason for this.

One other thing I am not sure about is whether the chart accounts for the change in reserve requirements (or lack of).  Back in March, one of the unprecedented moves made by the Fed was the elimination of reserve requirements.  Therefore, anything a bank has in reserves now should be included as excess reserves.

So there is no question that bank reserves have once again increased in tandem with the Fed’s balance sheet.  But not all of the new money is being held as reserves, which means at least some of it has been lent out.  The more that is lent out, the more likely we are to see higher price inflation.

With the monetary inflation that we have already seen, coupled with the Fed’s promises of continued loose money, I will be very surprised if we don’t see higher price inflation than what was seen after 2008/ 2009.

The CPI is already running higher in the midst of a recession.  And strangely enough, stocks are hitting all-time highs in the midst of a recession.

We haven’t even begun to see the total wreckage from the lockdowns of 2020.  In fact, the lockdowns aren’t even over in most places, and many businesses are never coming back.  We are seeing a dramatic increase in federal government spending at the same time that tax collections are likely falling.  I’m sure the Fed will continue to finance the majority of the deficit.

The newly created money distributed through government spending is going all over the place. Some of it went to small business owners.  Some of it went to people on unemployment.  Some of it went out as direct “stimulus” payments.  As usual, some of it went to special interests and their lobbyists.

When people were sitting at home not working and collecting a higher salary than before, it is easy to see how they would have spent even more than usual.  But the high unemployment checks have already been reduced and will likely keep going down.  Reality will start to set in for some people.  Reality has already set in for tens of thousands of business owners.

When the wreckage becomes clearer, there will be opposing forces pulling on inflationary pressures. A deep recession will likely lead to people saving more money and spending less.  At the same time, the Fed is likely to create even more new money, which should pull price inflation higher.

This is why diversification is so important.  It is why it is important to get out of debt, save money, and also protect some of your wealth with hard assets.  You don’t know which way this is going to go.  Perhaps we will see stagflation like the 1970s.  If that’s the worst we get, I will almost be thankful.