Recently and with little fanfare, Larry Kudlow, President Trump’s chief economic adviser, brushed against an unmitigated truth: “My hope is that the [Federal Reserve] under its new management understands that more people working and faster economic growth do not cause inflation.”
Kudlow got it right. The truth of the matter is that the word “inflation,” when used by economists in what might be called its “old-fashioned definition,” strictly refers to an expansion or inflation of the money supply, whether by way of the printing press, discovery of silver or gold, or (in a modern context) by deliberate Fed policy actions.
But word usages change. Today, inflation’s broader and more popular definition refers to a rising price level, or a situation in which all prices taken together increase. Inflation, then, is the result of too much money chasing too few goods. It is not caused by too many people working or an economy operating in overdrive. Kudlow was indirectly urging the Fed not to raise interest rates to slow the economy out of misplaced fears that higher growth alone would lead to rapidly rising prices.
But what about the old-fashioned definition? How do we get an inflated money supply or too much money? Money enters the economy when banks make loans. Through rules associated with required bank reserves and other regulations, the Fed can inspire an increase or decrease in lending. Given Fed reserve requirements, banks currently have a vast amount of excess reserves, which is the stuff for making loans.
Thus, the Fed possesses a huge ability to inflate the money supply. But until very recently, major banks have been operating under tight regulatory standards that date back to the Great Recession. These are now being relaxed.
So will banks open the money faucets? Will we have too much money in the chase?
Maybe, but there is another sometimes-overlooked piece to the puzzle: U.S. taxpayers pay interest to banks on their excess reserves to the tune of 1.95 percent annually. Given that this Fed-offered rate is 100 percent guaranteed, banks will not lend money unless they earn more, on a risk-adjusted basis, than what they get from the Fed on these excess reserves. Market interest rates, as opposed to Fed-determined interest rates, are rising now, and there is a wee bit of evidence that banks have increased lending as a result.
But as of now, it doesn’t appear that increased lending is putting “too much money” into our economy. And if the Fed does keep raising rates as its leaders have indicated, the rate paid to banks for not lending will rise, too.
Kudlow is correct. Ultimately it is too much money chasing too few goods that produces an inflationary outcome; it is not economic growth or prosperity. At present, there is no meaningful evidence that the money faucets are truly opening, but that will happen if market-determined interest rates continue to rise.
Bruce Yandle is a contributor to the Washington Examiner’s Beltway Confidential blog. He is a distinguished adjunct fellow with the Mercatus Center at George Mason University and dean emeritus of the Clemson University College of Business & Behavioral Science. He developed the “Bootleggers and Baptists” political model.
