As Deficits and Money Printing Increase, So Do Fears of Inflation

The US Federal Reserve and Treasury are repeating one of the most disturbing episodes of the 1940s and risk stoking a destructive inflationary boom, a leading monetary watchdog has warned.

The Centre for Financial Stability (CFS) in New York says US money supply data is flashing a red alert and that excess reserves in the banking sector threaten to set off an “explosion of lending” as the recovery accelerates. The Fed is riding a tiger by the tail and may have great difficulty extricating itself from a torrid monetary experiment that is reaching its limits.

The CFS said its "divisia" measure of the broad M4 money supply rose 24pc in March from a year earlier, and narrow its M1 variant rose 36.9pc. “Those monetary growth rates are potentially alarming,” said Professor William Barnett, the institution’s director.

Barnett said de facto collusion between the Fed and the Treasury is much like the 1940s, when the Fed served as a fiscal agent for Democratic administrations and mopped up the vast bond issuance needed to pay for the Second World War and its aftermath. Inflation reached 17pc by mid-1947 and creditors were gradually expropriated in what amounted to a stealth default stretched over several years.

The US output gap has already closed and President Biden’s $6 trillion fiscal plan is expected to push economic growth above its pre-pandemic trajectory by next year. Five-year "breakevens" measuring inflation expectations have jumped to 2.71pc, the highest since the pre-Lehman boom. Yet the Fed is continuing to buy $120bn of bonds each month.

The situation is fundamentally different from waves of QE after the global financial crisis. Stimulus at that stage was needed to offset a contraction of the money supply as banks slashed lending and sought to beef up their capital ratios to meet tougher Basel rules. Today’s QE is monetisation of fiscal deficits and is leading to a surge in bank reserves. This money will catch fire if monetary velocity returns to normal as the economy recovers. 

The Bank for International Settlements - the venerable club of global central bankers in Basel - also fired a shot across the bows on Thursday, warning that it would be a grave error for policymakers to let rip on monetary growth in the hope that social inequalities could be cured with inflationary stimulus. 

The poor tend to suffer most when the consumer prices suddenly start to rise. Agustin Carstens, the managing director of the BIS, said: “We should not forget the long-lasting scars of uncontrolled inflation on inequality. History abounds with episodes of high and runaway inflation that increased poverty and inequality via sharp reductions in real wages.

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