Crumbling monetary cliff

Fed/money supply: Expanding money supply in the United States could erode the Federal Reserve's logic on inflation. The Federal Open Market Committee on Wednesday again indicated that its zero to 0.25 percent interest rate target would be in place for “an extended period.” It also admitted that inflation had risen, but claimed it would fall again.

The money supply trends raise questions about that sanguine view on prices. Both the FOMC and Fed Chairman Ben Bernanke, in his second post-FOMC press conference, said the slowdown in growth and job creation this year as well as the acceleration in inflation over the same period, were temporary in nature. Factors in both include the Japanese earthquake and tsunami in March, which disrupted supply logistics, and the surge in commodity prices, which has now reversed somewhat.

Money supply data suggest, however, that Fed policy itself, in particular the $600-billion program of Treasury bond purchases, may have exacerbated recent inflationary pressures and could make further price rises more likely. The US monetary base – a measure of currency in circulation plus bank deposits at the Fed – has surged at an alarming 73.5 per cent annual rate in the first half of 2011, after holding more or less flat during 2010. Broader monetary aggregates, the M2 measure and the St Louis Fed's money of zero maturity, are also experiencing accelerated growth, albeit less dramatic – the latter at a 12.3 per cent rate since April. The Fed's reduced outlook for economic growth and slower forecast for the decline in unemployment both militate against inflationary pressures. But money supply expansion tends to work the other way.

Commodity prices, too, are unlikely to remain docile while global growth is solid and short-term interest rates in major markets are mostly below the level of inflation. In April, the FOMC said inflation was "somewhat low." The committee has already had to modify that view significantly. Indeed, price increases need to subside, as the Fed hopes they will, or the central bank will have to think hard about raising rates to bring inflation back down safely into its comfort zone.