I've made a living out of exposing economic fallacies by illuminating them with the spotlight of truth. One of the major fallacies rummaging around Wall Street today is that the increase in the monetary base and the Fed's balance sheet has not had an inflationary impact on our economy. Their belief goes something like this; The money the Fed has created and dropped from helicopters has all been caught in the trees. In other words, the Fed can create money but it is just held as excess reserves and isn't loaned out by the banking system to the public. Therefore, money supply doesn't increase, there is no money multiplier effect and aggregate price levels behave themselves.
But this is only a half truth. It is indeed a fact that most of the money created by the Fed is kept by commercial banks as excess reserves held at the central bank. However, this overlooks a key point. The Fed doesn't manifest reserves by magic. The central bank first creates an electronic credit by fiat and then purchases an asset held by a financial institution. Those primary dealers then deposit that Federal Reserve check. The act of creating money from nothing and buying an asset-be they Treasuries or Mortgage Backed Securities (MBS)-drives up the prices of those assets. And those asset price distortions create imbalances in the economy.
Therefore, the inflation created by the Fed first gets concentrated in whatever asset they have chosen to purchase. In the latest example of the Fed's monetary manipulations, Bernanke and company purchased $1.25 trillion in MBS. The prices of MBS were driven up and yields were pushed down by a massive artificial intervention into the market. Additionally, the FOMC decided back in December of 2008 that the overnight lending rate between banks should be near 0-25 bps. The Fed forced the entire yield curve lower by not only purchasing Treasury bills but also $300 billion in notes and bonds. The Fed has also recently indicated that it will be swapping maturing MBS dollars for longer dated Treasury securities in an effort to keep their balance sheet from shrinking.
So while it is true that-for now at least--we have been spared from the imminent curse of hyperinflation, thanks to the falling money multiplier, it is blatantly untrue that the trillion + dollars the Fed created has been rendered impotent and inconsequential.
Not only has the latent and real inflation represented by a huge buildup in the monetary base put pressure on the U.S. dollar and caused gold to soar, but it has also sent an egregious and distortional price signal for U.S. debt securities. The Ten year note is now trading just above 2.5%. That yield is near its all time record low, nearly 5 percentage points below its 40 year average and 13 percentage points below its record high level set in September of 1981.
While Wall Street and Washington are petrified over the deflation monster, the real boogie man to fear is the bubble government has helped create in the bond market. U.S. sovereign debt should only be enjoying their historically low yields due to a superfluous savings rate, low inflation and low debt. None of those preferable conditions currently exist. Hence, it is instead on a global scale; the most over-supplied, over-owned and over-priced asset in the history of the planet. Once the debt dam breaks it will send the dollar and bond prices cascading lower. Protect yourself now before the deluge drowns your investments.