The violent market reaction to the outcome of the Fed meeting is surprising. The Fed funds rate has traded consistently below 0.25% since early December while the quantitative measures described in the statement had already been announced or flagged in Chairman Bernanke's speeches.

The Fed’s recent interventions to boost credit flows and the money supply directly are warranted, although such action could have been taken without cutting official rates to almost zero. However, the risk that the Fed is creating the conditions for another upsurge in inflation needs to be recognised.

Deflation in the US in the 1930s and Japan in the 1990s was associated with a contraction of the broad money supply – see here. The chart shows annual growth rates of three measures of US broad money. None is near the danger zone. (M2 comprises currency, checkable deposits, small-denomination time deposits, savings deposits and retail money funds. M2+ adds large time deposits and institutional money funds, while the liquidity measure also includes Treasury bills and commercial paper.)

The Fed’s actions are already leading to an acceleration – M2 rose by an annualised 17% over the last 13 weeks. There is a good chance that the annual growth rates of all three measures will move into double-digits in early 2009. In the short term, this will provide important support to activity and reduce the (small) risk of the economy entering deflation but the price of success may be a renewed increase in inflation from mid 2010.