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Why isn't the Fed more worried about inflation?

I thought some readers might find it helpful to understand why the Fed doesn't appear to be as concerned as many commentators about the risk of future inflation.

Note that I'm not writing this explanation because I necessarily think the Fed is right and its critics are wrong. This is simply to help you understand both sides of the argument a little better.

With the disclaimer that I'm not an economist (nor do I play one on TV), here's a quick, general explanation of why the Fed is doing what it's doing.

The Quantity Theory of Money helps visualize this. Simply put, this theory says:

M * V = P * Q

M = Money in circulation
V = Velocity of money (how fast is the money being turned over, how much lending is going on)
P = Price level
Q = Growth of the economy

What critics have focused on (really for the past two years) is how the Fed has dramatically boosted M (the money supply). The fear is that all this extra money eventually drives up P (prices). In other words, that eventually the extra money translates into significant inflation.

What this ignores is the fact that at the same time M has gone way up, V has gone way down. This is why everyone has been clamoring for the banks to lend more (while also clamoring that they should tighten their lending standards and hold more reserves — never mind that doing all three of these things simultaneously is impossible).

As Paddy Hirsch notes in the video in the post below, people aren't borrowing or spending, banks aren't lending, taking the velocity of money way down. The money supply was dramatically increased in response to this, with the goal of offsetting that sharp decline. This is why we haven't seen the big spike in inflation that many have feared despite the fearsome charts everyone has seen showing the increase in the monetary base.

Without that spike in money supply, what does our formula say would happen? If M stays the same but V drops sharply, the formula says that (P)rices and or (Q) Growth are also going to drop sharply. Neither of those are good outcomes, so it's pretty easy to understand the Fed's response.

Back to the formula. MV=PQ. If (V)elocity is low, (P)rices are stable, and you want to boost Q (growth of the economy), how do you do it? By increasing M, the monetary base. Which is what the Fed is trying to do with its QE2 policy.

The danger, of course, is that as growth starts to increase, the velocity of money will also increase (more buying, borrowing and lending). If that happens while the money supply is still high, that's when P would be expected to climb higher and we'd have inflation.

The good news is the Fed has various ways (so they tell us) to reduce the money supply before that point. The bad news is it's difficult to know exactly when to do so and by how much.

Is there room to question Bernanke and what the Fed is doing? Sure — I have plenty of questions myself. Is Bernanke crazy and recklessly driving us off the edge of a cliff, as some observers seem to think? That's probably a tougher case to make than the critics suggest.

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