Lots of people began worrying about inflation when the Federal Reserve began QE back in 2008. Some even predicted “inflationary disaster,” warning that the monetary base cannot quintuple without a correlating rise in consumer prices.

For a while, I believed these guys. I was an undergraduate economics student at the time, and their logic made sense to me. Increasing the money supply will increase nominal prices, right?

Not quite. It’s true that increasing the supply of money will increase nominal prices, but QE didn’t increase the money supply, per se. It’s immediate effect is to increase the level of base money, which doesn’t change the supply of circulating money. What matters for price inflation, of course, is circulating money.

The reason we didn’t see the type of inflation these inflation-hawks warned about is because the new base money did not increase the M1 money stock (circulating money) like they predicted. They didn’t account for the Fed’s ability to control the rate at which this new money raises the M1 money stock via the interest it pays on base money accounts. And of course, the Fed has every incentive to keep inflation under control.

I’ve written about this before. When the Fed creates money, they don’t inject it into the economy with the intent that it has an immediate, proportional effect on consumer price levels. They deposit the new money into banks’ accounts at the Fed, where it collects interest. This has the effect of increasing bank reserves relative to the M1 money stock. It’s up to the banks, then, how they use these levels of reserves to increase lending activities and grow their balance sheets. By and large, banks have been quite conservative in this regard.

To put it simply, what these inflation-hawks should have been watching was not the amount of QE or growth in the monetary base, but the rate at which base money sparks more lending. That rate has been pretty low.

Now back to the title of this post…

The reason QE’s end should raise inflation fears is because, on the margin, banks will begin lending more to make up the difference from revenue lost because of QE’s end. For years, these banks’ reserve accounts at the Fed have been growing and earning interest. Now they’ve stopped growing (though they still earn interest).

Of course, banks don’t necessarily have to make up this difference. It’s just base money, and big banks aren’t anywhere close to being reserve-constrained. But as I said above, this tendency will happen on the margin. Not every bank will increase lending, but their incentives have now changed in favor of more lending and less hoarding.

I think the reason why we should fear inflation more now that QE is over is clear: Banks have less incentive to hoard cash in their Fed reserve accounts, as these accounts will now grow at a slower rate. The only way to make up this difference is to invest elsewhere. This will have the effect of turning base money into circulating money more often (technically, this is an increase in the M1 money multiplier, which we indeed saw every time QE ended in the past six years).

But prices respond to more than just changes in the money supply. These extra-monetary influences are likely to be stronger in the short-term—especially the appreciating dollar. So I’m not saying to brace for hyperinflation next month, or even any inflation next month. These things take time. Price inflation always lags behind monetary inflation. But I do predict that banks’ propensity to lend will increase, ceteris paribus. This type of inflation–not price fluctuations due to things like fluxing foreign demand, appreciating dollar, etc.–is what matters from a business cycle perspective, and what drives robust, sustained, real monetary inflation in the long term.