Will the Fed's latest action boost the economy?

Thursday, November 11, 2010; 7:15 PM

In his Nov. 4 op-ed, "Aiding the economy: What the Fed did and why," Federal Reserve Board Chairman Ben S. Bernanke argued in support of his new round of asset purchases that such quantitative easing (what's being called QE2, for short) will not lead to significant increases in inflation. Mr. Bernanke asserted that QE1 "had little effect on the amount of currency in circulation or on other broad measures of the money supply, such as bank deposits. Nor did it result in higher inflation."

True, but what QE1 did was to increase bank reserves by $1.5 trillion. This expansion of high-power money largely failed to increase bank lending and economic activity. Moreover, the Federal Reserve started to pay interest on banks' excess reserves, thereby affording banks a risk-free investment rather than putting their excess reserves into a riskier loan portfolio. With banks only required to hold a 10 percent reserve against their loans, the potential exists for a huge expansion in the transaction money supply and rapid inflationary pressures as the pace of the economy quickens.

The Fed chairman is confident that "we have the tools to unwind these policies at the appropriate time." But can the Fed tell time? Despite the slack in the economy, commodity prices are up about 7 percent from a year ago, prices on grocery shelves have recently moved up sharply, and the stock market is bubbling. QE2 provides all the ingredients for a bad bout of inflation when growth quickens.

Martin Gerra, Kensington

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