All of this changed in 2008, when a legislative reform allowed the Fed to
pay interest on excess reserves. The commercial banks could sell Treasury bills and longer-term bonds to the Fed, receive reserves in exchange, and earn a small but very safe return on those reserves.
That gave the Fed the ability in 2010 to begin its massive monthly purchases of long-term bonds and mortgage-backed securities. This quantitative easing (QE) allowed the Fed to drive down long-term interest rates directly, leading to a rise in the stock market and to a recovery in prices of owner-occupied homes. The resulting rise in household wealth boosted consumer spending and revived residential construction. And businesses responded to this by stepping up the pace of investment.
Although a link between the Fed’s creation of reserves and the subsequent increase in spending remained, its magnitude changed dramatically. The Fed
increased its securities holdings from less than $1 trillion in 2007 to more than $4 trillion today. But, rather than being used to facilitate increased commercial bank lending and deposits, the additional reserves created in this process were held at the Fed – simply the by-product of the effort, via QE, to drive down long-term interest rates and increase household wealth.
That brings us back to the apparent puzzle of low inflation. The overall CPI is actually slightly lower now than it was a year ago, implying a negative inflation rate. A major reason is the decline in gasoline and other energy prices. The energy component of the CPI fell over the last 12 months by 19%. The so-called “core” CPI, which excludes volatile energy and food prices, rose (though only by 1.8%).
Moreover, the dollar’s appreciation relative to other currencies has reduced import costs, putting competitive pressure on domestic firms to reduce prices. That is clearly reflected in the difference between the -0.2% annual inflation rate for goods and the 2.5% rate for services (over the past 12 months).
Nonetheless, inflation will head higher in the year ahead. Labor markets have tightened significantly, with the overall unemployment rate down to 5.4%. The unemployment rate among those who have been unemployed for less than six months – a key indicator of inflation pressure – is down to 3.8%. And the unemployment rate among college graduates is just 2.7%.