A lot of people think there’s no inflation yet and that the current scenario is only deflationary. Monetary reserves are contracting, they say. They point to the Fed’s open market operations as a form of adjustment (taking money from banks with bad debt by buying up mortgage debt and giving to banks in good shape through the sale of Treasuries).

Steve Saville points out why their argument is wrong and why inflation exists along with asset deflation:

“Many pundits still treat M1’s growth rate as an important indicator of monetary conditions on the basis that the amount of ‘narrow money’ is supposed to have a substantial influence on the total supply of money due to the famous “money multiplier” effect. In fact, some well-respected analysts have expressed concern that the lack of growth in the narrowest measures of US money supply over the past couple of years means that Fed policy has been excessively restrictive. But these analysts are failing to appreciate that regulatory changes made by the Fed in the early 1990s caused M1 to become a shadow of its former self with respect to its usefulness as a general monetary indicator.

In rough terms, the rules were changed in the early 1990s to allow banks to dramatically reduce the amount of money held in the form of reserves at the Fed by “sweeping” money from checking accounts (components of M1 that are subject to reserve requirements) into savings accounts (non-M1 components of M2 for which there are no reserve requirements). For example, you might think you have a checkable deposit at your local bank, but in the bank’s books you probably have a zero-interest CD (the type of deposit that has no reserve requirement). Whenever one of your checks is presented the bank’s software “sweeps” the relevant amount of money from the zero-interest CD you never knew you had into the checking account you thought you had.

These rule changes have made commercial banks more profitable because money held in reserve at the Fed is money that doesn’t generate income for the banks; and this, of course, is why the changes were made in the first place.”

Steve Saville in The Speculative Investor