This post originally appeared on The Finance Buff.
There has been a lot written lately about the possible effect of Federal Reserve activities on the inflation rate.
One person I trust on this topic is economics professor James Hamilton (UC San Diego). He tracks the Fed’s balance sheet pretty carefully and has put out an exceptional post that explains its recent activities and the extent to which they’re inflationary. He followed up that post with another good one and I’m sure there will be more.
I encourage you to read Hamilton’s posts on this topic. In summary, in the above-referenced posts he shows that very few of the dollars the Fed has pumped out recently have entered circulation. Banks are sitting on most of it because they’re not lending. The Treasury Department soaked up some more by issuing additional US debt. Meanwhile, what the Fed has mostly been doing is swapping its Treasury holdings for other types of assets.
In the vernacular of macroeconomics, the Fed has been utilizing qualitative easing. On paper they have also been engaging in quantitative easing. Since the funds have ended up in bank reserve accounts or in Treasury accounts and not in the hands of the citizenry, effectively the amount of quantitative easing has been small so far.
The tricky bit down the road is how quickly the Fed can soak up dollars if and when inflation shows up. To facilitate doing so, the Fed wants to hold assets that would be in high demand during times of inflation. This is why Hamilton recommends the Fed buy TIPS.
Nevertheless, he says that inflationary pressures remain under control at the moment, “but stay tuned.”
April 12, 2009 update: How the Fed induces banks to hold on to reserves above the required minimum is explained clearly in this post by Susan Woodward and Robert Hall.