Are we headed for 15% inflation?

That's the question asked by Steven Cunningham in an article at IDB today. He believes it possible that by late 2013, the massive amount of cash dumped into the economy by the Federal Reserve might serve as a catalyst for a round of high inflation:

Since the economic meltdown began in 2008, the Fed has pumped an unprecedented amount of money into bank reserves. In 2011 alone, adjusted bank reserves increased at a compounded annual rate of 47.1%. As these bank reserves filter into the business and consumer economy, the risk of inflation rises.

Until recently, the reserves weren't going anywhere. The banking industry was taken to task for making risky loans before the economic meltdown. So they were happy to sit pat.

What's more, in October 2008 the Fed started paying interest on reserves held at the Federal Reserve Banks. Apparently designed to help buoy bank balance sheets, this made it profitable for banks to forgo lending in favor of the low-risk profit provided by the Fed's interest payments.

Banks are currently holding about 15 times more than the roughly $100 billion in reserves required by the Fed, or $1.5 trillion. Historically, banks -- which make profits primarily by lending out money, not keeping it -- have held only 1% or 2% over required reserves.

Even at the current lending rate, the money supply has been growing faster than the economy. In December 2011, M2 -- the money supply measure that includes currency, checking accounts, savings accounts, money-market mutual funds, and traveler's checks -- grew at a year-to-year rate of about 10%. The U.S. economy during this period grew at 2.8%.

Assuming no changes to the financial or payments system, this translates to a potential inflation rate of 7.2% (10% less 2.8%). This is basic monetary policy arithmetic. But it only considers money currently in circulation. Given the current volume of bank reserves, more money is certain to enter circulation, increasing the risk of even higher inflation.

Cunningham points out that the number of bank loans increased by a whopping 11.3% since October of 2010. All that cash tied up in reserves by the banks is now going to rapidly be dumped into the economy.

What will be the effect? The Fed says it will be able to drain the reserves before inflation becomes a significant problem. This might be a fantasy. No central bank has attempted such a feat on this scale. And the Fed must walk a fine line between draining too much in reserves, which could create a credit crunch, or too little which would fuel inflation.

Economists have been predicting inflation for the last two years, but the economy was so moribund, prices were actually falling. Now that the economy is heating up, inflation is rearing its ugly head and unless the Fed can perform better than it has in the past, we are likely to see a steep rise in prices.