Harvard’s Feldstein: Fed's Strategy Is Inflation Time Bomb

According to Harvard economist and former Reagan economic adviser Martin Feldstein, unless carefully managed, the huge expansion of US liquidity could drive up inflation. Feldstein continues saying that it would require a great deal of skill for the Fed to avoid the rise in inflation that existing liquidity has already created.

Wednesday, 04 Apr 2012 08:15 AM
By Julie Crawshaw
Money News

Harvard economist and former Reagan economic adviser Martin Feldstein says the huge expansion of U.S. liquidity could drive up inflation unless it's carefully managed.

“The large volume of reserves, together with the liquidity created by quantitative easing and Operation Twist, makes that risk greater,” Feldstein writes in the Business Standard.

“It will take skill – as well as political courage – for the Fed to avoid the rise in inflation that the existing liquidity has created.”

That risk is real, but not inevitable, says Feldstein, because the relationship between the reserves held at the Fed and the subsequent stock of money and credit is no longer what it used to be.

"The explosion of reserves has not fuelled inflation yet, and the large volume of reserves could in principle be reversed later," Feldstein says. "But reversing that liquidity may be politically difficult, as well as technically challenging."

Anyone concerned about inflation has to focus on the volume of reserves being created by the Fed, Feldstein notes.

“Traditionally, the volume of bank deposits that constitute the broad money supply has increased in proportion to the amount of reserves that the commercial banks had available,” he says. “Increases in the stock of money have generally led, over multiyear periods, to increases in the price level.”

“Therefore, faster growth of reserves led to faster growth of the money supply—and on to a higher rate of inflation. The Fed in effect controlled—or sometimes failed to control—inflation by limiting the rate of growth of reserves.”

Bloomberg reports that most economists don't think Fed officials will change their interest-rate policy at their next meeting on April 24-25 and will ease credit only if the economy slows further.

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