Is Inflation Ahead?

The Financial Counselor


DURING the past two months the financial journals have been discussing the possibility of inflation. In the European press the headline ‘Inflation in America’ has appeared repeatedly. At home hardly a day passes without some comment on the possible danger which is presaged by the expansion of our bank credit.

The Federal Reserve situation and the policy of the Federal Reserve System stand at the centre of this discussion. ‘The Federal Reserve is losing gold.’ ‘The member banks of the system are increasing their rediscounts.’ ‘The reserve banks themselves are selling government securities and raising their rates.’ Thus runs the comment .

Brokers’ loans are still expanding at the middle of May. Early in the year it had seemed as though February, or at the latest March, would see a marked decline in their level. This situation has brought loud accusations against the Federal Reserve System.

The average citizen reads and wonders whether we are really rushing down the road to inflation, that nightmare of post-war finance.

One of the difficulties in answering this question for the layman is the lack of agreement as to the meaning of the term. It used to be assumed that a stable or declining price level for commodities was the best evidence that no inflation existed, If in addition there were ample reserves of gold behind the credit structure, then surely it was absent. Evidently many people no longer accept this as a satisfactory test, for commodity prices have declined rather than risen during the past five years. Our gold reserves are still much larger than the mandates of Jaw or the dictates of prudence call for.

Perhaps the most helpful treatment of the problem is to set forth the present condition of the reserve banks, and to contrast it with one that was clearly recognized as inflation, and with another that was as clearly deflation. Then the reader may judge for himself whether the banks are dangerously close to the former.

We have witnessed one period of inflation during the past decade. It came in 1920, and the echoes of the crash which followed in its wake are still reverberating.

At that time, surely, we bad an inflated credit structure. The gold holdings of the Federal Reserve System were down to less than two billion dollars. The rediscounts of the member banks were up to two and one-half billion; and the total bills and securities—the earning assets, as they are commonly called — of the twelve Federal Reserve banks totaled more than three billion dollars. The Federal Reserve notes in circulation, which constituted the great bulk of paper money in the purses of the public, amounted to over three billion. The reserve ratio was down to 42 per cent, which was close to the legal minimum.

This was the situation in May 1920, and it constituted inflation in full flower.

How does the condition in May of this year compare with that of eight years ago?

Considering the important items in order, we find first of all that the gold reserves on May 9 of this year are $700,000,000 larger; they stand at almost $2,700,000,000 now as compared with less than $2,000,000,000 then.

The rediscounts of the member banks are under $800,000,000, as contrasted with $2,500,000,000 at the earlier date; and the total bills and securities are $1,400,000,000 as against $3,200,000,000.

This latter figure of total bills and securities is of especial significance, since it measures the extent to which the public and the member banks are leaning upon the credit resources of the Federal Reserve banks. It stands to-day at less than one half the sum which it had reached in 1920. The Federal Reserve notes which we carry in our pockets have declined from over $3,000,000,000 to $1,600,000,000. They have been replaced by the yellow-backed gold certificates which have become so familiar to the public during the last five years. We imported gold in such amounts during this period that the Federal Reserve decided to put it into circulation rather than carry it as reserve.

As a consequence of this increase in gold reserves on the one hand and the decreased note circulation on the other, the reserve ratio of the system has risen to 70 per cent as against 42 per cent during the year of inflation.

The present condition of the Federal Reserve banks is certainly far from inflation.

But how far does it stand from deflation? It is conceivable that, though we have not yet arrived at inflation, we may be far enough removed from the conservative situation which followed the depression of 1921 to give us concern.

By May 1922, our credit structure was thoroughly deflated. The loans of the member banks had fallen to their lowest point because of the shrinkage in the volume of productive activity and the staggering fall of commodity prices. Bills discounted had declined from $2,500,000,000 to one fifth that amount, and the total earning assets from $3,200,000,000 to $1,200,000,000. The gold reserves had increased a full billion, and the Federal Reserve notes in circulation had declined a like amount. As a result the reserve ratio rose to 77 per cent.

There was universal agreement that the banking system had been purged of inflation. We had imported a billion dollars of gold, and the public needed a billion dollars less currency to carry on the smaller volume of business at reduced prices. Both these sums were deposited in the member banks, which in turn handed them over to the Federal Reserve banks and paid off their rediscounts.

The spring of 1922 marked the end of deflation for the member banks. Presently their loans began to increase, and from the low-water mark of seventeen billion dollars these have risen steadily to over twenty-four billion. During the same period their holdings of securities have grown from six and one-quarter billion to ten and one-half. But this expansion of bank credit to the public brought, no corresponding increase in the amount of Federal Reserve credit used by the member banks. On the contrary, the earning assets of the twelve Federal Reserve banks reached a new low mark two years later, in May 1924, when they fell to less than $800,000,000, as contrasted with $1,200,000,000 in May 1922. During these two years we imported $700,000,000 more of gold. Three hundred million of this went to meet the increased needs of circulation, and the rest was employed by the member banks to reduce the earning assets of the Federal Reserve banks. But this time they did not reduce their rediscounts; these were already at a low point. Instead they bought government bonds from the reserve banks. In short, they exchanged the incoming gold partly for gold certificates which they paid out to their depositors, and partly for government bonds which earned them interest where the gold would have earned them nothing. It was during this period that the phrase ‘worthless gold’ was used by one editorial writer. The exceedingly low volume of reserve credit outstanding at that time was looked upon as clearly abnormal. The reserve ratio had risen to over 83 per cent.

After some increase in the use of reserve credit during 1925 and 1926, the system found itself again, in the spring and summer of 1927, almost as thoroughly deflated as in 1924, and markedly easier than in 1922. For in May of last year the member banks were actually using less reserve credit than five years earlier, and the reserve ratio was 80 per cent.

Even in August of last year gold reserves were still three billion dollars, rediscounts less than half a billion, and earning assets only slightly more than one billion.

This was almost identically the same situation as in May 1922. Only in the note circulation was there a marked change. This was smaller, because the Federal Reserve banks had not allowed the imported gold turned over to them by the member banks to swell the gold reserves, but had put it into circulation in the form of gold certificates.

Since last year the picture has changed. Our gold reserves have decreased almost four hundred million dollars, and the rediscounts of the member banks have risen almost exactly the same amount. The earning assets of the reserve banks exceed $1,400,000,000, and the reserve ratio has fallen to 70 per cent. The reason for these changes is found in our gold exports.

The member banks had turned the gold which they imported over to the Federal Reserve banks, as it flowed in between 1921 and 1927. Now certain foreign nations, notably France and the Argentine, are asking those banks to send them gold in return for loans and for money which those nations had previously been investing in our market. The member banks must get it from the Federal Reserve, which has it in custody. When they receive it, they must give something in return. If the Federal Reserve banks were buying back the government securities which they previously sold to the members, these could be exchanged for the gold. But the central banks are not increasing their holdings of securities, therefore the member banks are rediscounting commercial paper and borrowing on government bonds as collateral. They have borrowed only the amount needed to get back a small part of the gold which they originally paid over to the reserve banks.

Is this inflation? Hardly. Nor is it even an approach to that dread state.

During these last nine months we have exported some of the ‘worthless gold’ which we had in our possession; and we have received from foreigners in return for it bills of exchange and securities which bear interest where the gold earned nothing. Inflation may come as a result of expanding business, increased note circulation, and the loss of gold reserves through exports. But these movements would have to be so great that their consummation is highly improbable in the near future.