Will New Fed 'Tools' Avert Hyperinflation?

From Lewrockwell.com

Now the reason prices haven’t exploded is that the demand to hold U.S. dollars has also increased dramatically. (That’s also what happened in the 1980s: the Reagan tax cuts and Volcker’s squelching of severe price inflation made it much more attractive to hold dollars, and so the Fed got away with printing a bunch even though the CPI didn’t increase wildly.)

Once people get over the shock of the financial crisis, the new money Bernanke has pumped into the system will begin pushing up prices. Others have used this analogy before me, but it’s still apt: The U.S. economy right now is like Wile E. Coyote right after he runs off a cliff but hasn’t yet looked down. Once the spell of a “deflationary spiral” is broken by a full quarter of significant price hikes, there will be an avalanche as people come to their senses.

Some analysts concede that the traditional Fed policies have indeed left the dollar vulnerable to serious devaluation, but they think the central bank wizards can save the day by acquiring new “tools.” For example, San Francisco Fed president Janet Yellen has been arguing that the Fed should be able to issue its own debt, to give the Fed more flexibility. The idea is that when the time comes for the Fed to sop up the excess reserves it has pumped into the banking system, it would be devastating to the incipient economic recovery if the Fed has to dump a bunch of mortgage-backed securities, or Treasury bonds, back onto the market. This would ruin the banks with MBS on their balance sheets, and/or it would push up interest rates for the government. Thus, the Fed would have painted itself into a corner, and it would have to choose between massive CPI hikes or a renewed recession. To avoid that nasty tradeoff, Yellen argues that if the Fed could sell its own debt, then it could drain reserves out of the banking system without unloading its own balance sheet.

For a different idea, economists Woodward and Hall think the Fed just needs the ability to charge banks for holding reserves. The Fed already (recently) obtained the right to pay interest on reserves, and so Woodward and Hall think the Fed should also have the ability to do the opposite, i.e. to be able to pay a negative interest rate on reserves that banks hold on deposit with the Fed.

How does this avert the threat of hyperinflation? Simple, according to Woodward and Hall. If banks ever start loaning out too much of their (now massive) excess reserves, and thereby start causing large price inflation, then the Fed can simply raise the interest rate it pays on reserves. Banks would then find it more profitable to lend to the Fed, as it were, rather than lending reserves out to homebuyers and other borrowers in the private sector. Voilà! Problem solved.

Obviously these tricks can’t avoid the consequences of Bernanke’s mad money printing spree. At best, they would merely push back the day of reckoning, while ensuring that it grows exponentially (quite literally).