By timestaff
October 30, 2009

The Federal Reserve released on Thursday the latest details of its burgeoning balance sheet. In short, the assets on the Fed’s books now amount to $2.2 trillion. That’s more than double where it was a little over a year ago (when it stood at a mere $900 billion) — before the central bank bought tons of Treasury debt and mortgage-backed securities from the nation’s banks in the midst of last year’s credit crisis, putting government cash in the hands of those banks.

Now, when the Fed’s balance sheet is big and banks have all that extra money to lend, the usual impact is that the increased number of dollars in the economy are competing for the same amount of merchandise. Prices go up; in other words, we have inflation.

You may have noticed, however, that it’s not working that way. For the most part, in fact, prices are actually heading down. How can this be? Well, there are a few different reasons.

Chief among them is unemployment. People without jobs spend less. Fewer dollars compete for more unsold inventory. And so, stores can’t raise prices (and might even slash them).

Second, lenders’ balance sheets are still crummy, and they’re aware of the hardships others are facing. So they’re not lending as much as they used to. When the Fed floods them with money, they keep it in the vault, afraid of the kind of credit crisis that toppled some of their peers early this year and last year.

The big, unanswered question is what will happen when unemployment turns around (assuming it does) and banks start lending again. The Fed will attempt to sop up the extra money it gave to banks by selling some of its assets, including all those Treasury bonds and mortgage-backed securities it purchased last year. If the Fed times the sales correctly, it’ll re-absorb the extra cash before it drives up prices. If the Fed’s too early, it could push the economy back into a recession. If late, inflation could take hold.

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