In September 2020, the Fed’s preferred inflation gauge (Core PCE) was running at 1.6%, and Fed Chairman Jay Powell was worried about disinflation. The Fed bought $87 billion in Treasuries and $34 billion in mortgage bonds that month as part of an ongoing strategy to push inflation up to 2%.
Many thought the bond purchases were grossly inadequate and called for more fiscal support to avoid the “Japonification” of the US economy. But we disagreed and predicted, based on the Fed’s bond-buying experience during the Great Financial Crisis (GFC), that the COVID bond-buying program of the Fed would push inflation above 2% in February 2021.
We were a few weeks late. Core PCE inflation topped 2% in March 2021 and continued to climb from there.
So what did we see in 2020 that suggested rising inflation was in the making? And why is it important to move forward?
First consider why the Fed buys bonds to stimulate growth and inflation. Bond buying, or “quantitative easing” (QE), works through the so-called credit channel. In other words, it encourages banks to lend more. When the Fed buys bonds from banks, their cash reserves with the Fed increase. As this cushion of liquidity grows, banks have more incentive to lend. Cheaper and more abundant credit then encourages more spending and investment.
But the banks are not obliged to lend more. And during the GFC, they didn’t. From 2009 to 2015, as shown in the left-hand figure above, banks’ excess reserves (reserves above those required) increased alongside bond purchases by the Fed. As a result, inflation remained stable.
During the COVID-19 recession, however, banks behaved very differently. Between April and July 2020, the Fed purchased $321 billion in Treasury bills and $200 billion in mortgage bonds. And, as the figure on the left shows, bank reserves fell by $235 billion. QE worked as expected.
As the Fed continued its bond purchases, bank reserves began to rise again, but not as quickly as the pace of bond purchases. Thus, as shown in the figure on the right, the gap between the Fed’s Treasury holdings and the banks’ excess reserves has increased sharply. The predictable consequence of this growing gap has been inflation.
And the inflation we’ve had – inflation that has been steadily rising in 2021 and 2022, right up to today.
So where exactly did the Fed go wrong? Well, the decline in the spread between the Fed’s bond holdings and the banks’ excess reserves between January and April 2021 might have suggested that inflation would decline on its own. But as that spread started to widen again in May, with Core PCE inflation at 3.5%, the Fed clearly should have declared victory and ended its bond buying. Instead, he continued the binge for another 10 months. At that time, in March 2022, Core PCE inflation was at 5.2%, and the Fed should have raised rates.
The lesson for monetary policy is twofold. The first is that QE can and does stimulate lending and inflation through the credit channel. The second is that the gap between central bank bond holdings and bank reserves is a fairly reliable indicator of the direction inflation is heading, and that an unwanted pick-up in the gap is a signal that QE has may have exceeded its target. So central banks must heed former Fed Chairman William McChesney Martin’s warning and empty the punch bowl before the party begins.