By contrast, theFed’s purchases of long-term bonds during this period has been unprecedentedlylarge. The Fed bought more than $2 trillion of Treasury bonds andmortgage-backed securities, nearly ten times the annual rate of bond purchasesduring the previous decade. In the last year alone, the stock of bonds on theFed’s balance sheet has risen more than 20%.

The historical recordshows that rapid monetary growth does fuel high inflation. That was very clearduring Germany’s hyperinflation in the 1920’s and Latin America’s in the1980’s. But even more moderate shifts in America’s monetary growth rate havetranslated into corresponding shifts in the rate of inflation. In the 1970’s,US money supply grew at an average annual rate of 9.6%, the highest rate in theprevious half-century; inflation averaged 7.4%, also a half-century high. Inthe 1990’s, annual monetary growth averaged only 3.9%, and the averageinflation rate was just 2.9%.

That is why the absence of any inflationaryresponse to the Fed’s massive bond purchases in the past five yearsseems so puzzling. But the puzzle disappears when we recognize that quantitative easing is not thesame thing as “printing money” or, more accurately, increasing the stock ofmoney.

The stock of moneythat relates most closely to inflation consists primarily of the deposits that businessesand households have at commercial banks. Traditionally, greater amounts of Fed bond buying haveled to faster growth of this money stock. But a fundamental change inthe Fed’s rules in 2008 brokethe link between its bond buying and the subsequent size of the moneystock. As a result, the Fed has bought a massive amount of bonds withoutcausing the stock of money – and thus the rate of inflation – to rise.

The link between bond purchases and the moneystock depends on the role of commercial banks’ “excess reserves.” When the Fed buys Treasury bonds or other assets likemortgage-backed securities, itcreates “reserves” for the commercial banks, which the banks deposit atthe Fed itself.

Commercial banks arerequired to hold reserves equal to a share of their checkable deposits. Sincereserves in excess of the required amount did not earn any interest from theFed before 2008, commercial banks had an incentive to lend to households andbusinesses until the resulting growth of deposits used up all of those excess reserves. Those increaseddeposits at commercial banks were, by definition, an increase in the relevantstock of money.

An increase in bankloans allows households and businesses to increase their spending. That extraspending means a higher level of nominal GDP (output at market prices). Some ofthe increase in nominal GDP takes the form of higher real (inflation-adjusted)GDP, while the rest showsup as inflation. That is how Fed bond purchases have historicallyincreased the stock of money – and the rate of inflation.

The link between Fedbond purchases and the subsequent growth of the money stock changed after 2008,because the Fed began to pay interest on excess reserves. The interest rate onthese totally safe and liquid deposits induced the banks to maintain excessreserves at the Fed instead of lending and creating deposits to absorb theincreased reserves, as they would have done before 2008.

As a result, thevolume of excess reserves held at the Fed increased from less than $2 billionin 2008 to $1.8 trillion now, effectively severing the link between Fed bond purchases andthe resulting stock of money. The size of the broad money stock (known as M2)grew at an average rate of just 1.5% a year from the end of 2008 to the end of2012.

So it is notsurprising that inflation has remained so moderate – indeed, lower than in anydecade since the end of World War II. And it is also not surprising thatquantitative easing has done so little to increase nominal spending and realeconomic activity.

The absence ofsignificant inflation in the past few years does not mean that it won’t rise inthe future. When businesses and households eventually increase their demand forloans, commercial banks that have adequate capital can meet that demand withnew lending without running into the limits that might otherwise result frominadequate reserves. The resulting growth of spending by businesses andhouseholds might be welcome at first, but it could soon become a source ofunwanted inflation.

The Fed could, inprinciple, limit inflationary lending by raising the interest rate on excessreserves or by using open-market operations to increase the short-term federalfunds interest rate. But the Fed may hesitate to act, or may act withinsufficient force, owing to its dual mandate to focus on employment as well asprice stability.

That outcome is morelikely if high rates of long-term unemployment and underemployment persist evenas the inflation rate rises. And that is why investors are right to worry thatinflation could return, even if the Fed’s massive bond purchases in recentyears have not brought it about.