With the Federal Reserve Open Market Committee (FOMC) meeting this week, we are all reminded of what occurred the last time it convened. Traditionally, the FOMC meets to set interest rates. Having already reduced interest rates to near zero, the last meeting left little to be done on that front. However, the committee did not refuse to act. Instead, with a few strokes of the computer, the FOMC magically created over $1 trillion of new money to be pushed into the economy.
Recalling my college years, we were all taught that excess money floating through the economy leads to inflation. With precisely this goal in mind, the Federal Reserve (Fed) has increased their balance sheet from $866 billion a year ago to over $2 trillion. Despite such an increase, the inflation rate has not grown and more people remain worried about deflation than inflation. How can this be?
The answer lies with the money multiplier. Returning to the lessons of my economics classes of yesteryear, each dollar I spend has a multiplying effect on the economy. If I go to a restaurant for dinner and leave a $20 tip for the waitress, she then spends that money on her dry cleaning. The dry cleaner spends some of it to pay his employees, who then spend their share on groceries. Supermarket workers receive wages from the proceeds, go out to dinner, and start the process again. My initial $20 outlay has a multiplying effect that contributes to economic growth.
Using this process, we can estimate economic activity as the money supply multiplied by the velocity of money (the multiplier). Currently, the multiplier has collapsed as consumers have curtailed their spending. For that reason, the massive increase in money supply helps offset the economic collapse without igniting inflation.
That may explain our current state, but we all hope it is temporary. Eventually, the economy will resume growth and the multiplier will increase. At that time, the economy will respond to the Fed's injection of money and inflation will reappear. In theory, the Fed will interpret that event as a reason to reduce the money supply. If the Fed does this correctly, growth will be reasonable and inflation contained. Unfortunately, though, I have little faith in the Fed acting correctly.
Considering this is the same group that could not foresee any of the recent asset bubbles and has always had uncoordinated ad-hoc approaches to stemming crises, those who believe it will magically spot the turn in the economy and reduce monetary stimulus are naive. Further, even if the Fed possessed such forecasting skills, which it does not, the political pressure surrounding monetary tightening would be immense. As we have all lived through a horrible recession, any attempt to moderate growth will be widely scorned. The Fed will opt to keep the monetary spigot open while reminding us that Japan prematurely tightened monetary policy and quelled its own economic recovery.
As investors our job is to analyze this injection of cash for what it is smoke screen. The Fed has aggressively expanded its powers during this credit crisis and will seek to forestall congressional oversight of its future actions. Peace with Congress will exist with the Fed keeping rates low and the money supply high. For a time, the Fed's targeted buying of assets will achieve these goals, but the markets will eventually win. At some point, the leash will break, inflation will skyrocket, and the next bubble will burst.