Monetary expansion does not happen via banknotes raining down on the streets.

I have previously mentioned that during the global financial crisis Federal Reserves (FED) has injected substantial amounts of liquidity into the system first to put out the fire in the financial system and then to make the system able to extend credits again. I underlined that from July 2007 to December 2008 FED's balance sheet grew by 2.6 times. Size of FED's balance did not change yet.

Upon that commentary I received mails from some of my readers. They asked why this substantial monetary expansion did not push up the inflation rate. So today I would like to talk about the relation between monetary expansion and inflation. The literature on this subject generally refers to the statement 'Inflation is always a monetary phenomenon' by Nobel Prize Winner Milton Friedman. Then does the US case develop in the opposite direction? 

Avoid the 'pill'
To begin with we have to not take such 'aphorisms' as 'pills' but first read the prospectus. Monetary expansion does not happen via banknotes and coins raining down on the streets. Central banks issue currency and receive something in exchange. This could be state bills or borrowing securities of banks and firms.

Therefore, the issued currency does not directly go to the hands of the consumer and in many cases of investors (unless firms are directly credited). On the other hand, in order for the new liquidity to press up the inflation rate, it has to increase the demand for goods and services. In that case, banks should extend in terms of credits the liquidity they received as a result of the Central Bank operation do that the domestic demand elevates, consumption goes up and investments buoy. But if the credit market does not function property, such mechanism does not work.

An extreme example: Assume that FED lent all the newly issued money to Jo and Jo beds all the money underground in jars. He would need a considerably large garden and many jars to begin with. Say that he digs the garden toward the core of the supply. Or let's say that FED does Jo a favor and issues billion-dollar banknotes. Does demand go up then? It definitely does not. So why would prices hike? We should also consider that the issued money does not affect inflation expectations. Even if FED declares that they will give the money to Jo and Jo states that he will bed the money underground; expectations are not influenced and thus prices do not hike.

On the other hand unemployment rate in the USA is quite above the pre-crisis level. Economic recovery takes place slower than anticipated. To put it differently, installed capacity is not utilized completely. So in such a milieu, even monetary expansion stimulates domestic demand - which is not the case exactly as the credit market does not function properly - firms do not raise the prices and push up the profit margins since capacity utilization is low. Therefore, inflation rate does not hike.

Indeed, the US administration is currently busy with searching the answer to the question of how to stimulate demand; FED quests new measures. It is also seen that policy rate will not be increased for a certain while. 

This is not sustainable
This evidently is not sustainable. If the credit market is invigorated, demand will eventually rise and capacity utilization rate goes up. Then, inflation rate tends upwards. FED will seek to reduce the balance sheet and increase interest rates before things evolve that way. But when exactly? It is apparent that FED does not know this yet.

This commentary was published in Radikal daily on 06.12.2010