Inflation or deflation? Should the US Federal Reserve tighten up, drain reserves from the banking system and raise interest rates? Or should the Fed engage in a second round of massive quantitative easing?

At the beginning of the year, more and more economists, fearing an outbreak of inflation, were moving to the side of restraint. Today an increasing number of economists, including monetarists, fearing deflation are calling on Helicopter Ben, the Chair of the Fed, to initiate round two of quantitative easing. It is one thing for Paul Krugman to criticize the Fed for not doing enough to stimulate the economy. It is quite another when monetarists are joining this chorus.

In the monetarist world, the rate of inflation is driven solely by the rate of growth of the money supply. Since the Fed supposedly controls the money supply, the Fed should be responsible only for controlling the rate of inflation.

Monetary theory might be right over a five to 10 year time frame, and over time the rate of inflation might be driven primarily by the growth rate of the money supply. But monetary theory comes up short in predicting short-term economic fluctuations.

Monetarists will never accept this conclusion, so it was not surprising that most were shocked by the dramatic increase in the size of the Federal Reserve balance sheet orchestrated by Helicopter Ben, in response to the financial and economic crises in September 2008. Bernanke’s actions increased the Fed’s balance sheet, a proxy for the monetary base and the M2 version of he money supply, from $947 billion in July 2008 to $2.3 trillion in December 2008 – an increase of 140%.

Monetarists predicted that the skies would be falling and the inflation rate would skyrocket. The gold bugs jumped on the bandwagon predicting a future of hyperinflation in the US and the destruction in the value of all assets except gold.

The skies did not fall, and the inflation rate (excluding food and energy) has been trending downwards over the past 24 months. During the past 12 months, the rate of inflation in the US was only 0.9% When one takes into account the upward bias in the measurement of the CPI, a sub-1% rate of inflation indicates that prices likely are falling.

The monetarist model failed to consider the possibility that banks would not open the lending spigots in an environment filled with uncertainty about the strength and sustainability of the economic recovery. Yes, the money supply (M2 definition) did increase by 10% between July and December 2008. Since then the money supply has remained constant.

The Fed’s balance sheet today is $1.4 trillion (140%) larger than in July 2008, and the monetary base is 141% larger today than in July 2008. However, the banks have chosen to increase their holdings of excess reserves by over $1 trillion during the past two years (from $1.6 billion to $1.0 trillion). The banks are not interested in lending money.

So is another round of quantitative easing necessary?

When Bernanke, whom I still believe is the smartest person in Washington, persuaded his Fed colleagues to support the massive and innovative initiative to pump an additional $1 trillion of liquidity into the financial system, he did so for two reasons. The first was to reinforce the policy of zero interest rates. The second was to salvage the financial system by buying all types of financial assets and thus setting floors to their prices. This prevented a massive round of forced and panic sales of financial assets, which would have had the devastating consequence of destroying the banking system, both in the US and the rest of the world.

Asset prices, at least for most types of debt instruments, have stabilized, so there is no need for Fed intervention in these markets. On the other hand, the Fed needs to rollover its maturing assets in order to maintain the monetary base and the potential for banks to grow their loan portfolios. Buying longer-term government bonds, as the Fed is doing, is the right policy since this will keep long-term interest rates low, and long-term rates are much more important for corporate investment decisions than short-term rates, which have been effectively at zero for most of the past two years.

The Fed has not deviated from its policy course since September 2008 despite the changing tunes of its critics. And the Fed, especially Bernanke, continues to be smarter than its critics.

The opinions expressed in this blog are personal and do not reflect the views of either Global Brief or the Glendon School of Public and International Affairs.