The Wilder View

All of the buzzwords in one post: quantitative easing, inflation and printing money

I have received many emails from readers that are concerned about current Fed policy. In this post, I will address the following issues: what is quantitative easing; is the Fed printing money; and finally, will the Fed’s massive liquidity injections lead to inflation.

Quantitative easing (QE) by the Fed has begun. But before we can address the Fed’s QE strategy, we must get one thing straight. First, a QE policy is not a zero interest rate policy (ZIRP). The federal funds target is currently 1%, and although the Fed has initiated a QE strategy, it has not declared ZIRP…yet. The next scheduled meeting is December 15-16, where the Fed may very well set the policy rate equal to 0%.Without explicitly setting the federal funds target to 0%, the Fed is currently engaging in another non-traditional policy, quantitative easing (QE). Under a QE policy, the Fed increases bank reserves beyond levels consistent with ZIRP (technical definition according to Bernanke, Reinhart, and Sack). QE implies that the Fed no longer targets an interest rate.
The flood gates are open. The Fed is injecting the banking system with shiny new reserves (liquidity) and is no longer using open market operations to keep the effective federal funds rate – the overnight interbank loan rate – close to its target, currently 1%. In laymen’s terms, the Fed is printing money under the QE policy; the idea of the Fed printing money has clearly caused some confusion for readers. Printing money is a pejorative term that is often associated with inflation, or worse, hyperinflation. In normal times, a QE strategy would certainly result in newly available money, but we are not in normal times.
The Fed is not printing money, rather it is printing high powered money, where high powered money is the monetary base (reserves).What is the difference between money and high powered money? Money is a function of two things
  1. The monetary base, which equals bank reserves plus currency in circulation
  2. The money multiplier, or how quickly the base switches hands in a fractional reserve banking system (for a discussion of money creation, see this wiki article).

The Fed is raising the monetary base through its QE policy and increasing its balance sheet (credit extended to the banking system) from $884 billion on August 28 to $2.1 trillion on November 28. The Fed simply creates new monetary base (reserves) out of thin air; hence, the printing money connotation.



However, banks are hoarding the new base in the form of excess reserves, and lending has slowed significantly relative to the size of the new reserve base. Therefore, the money multiplier is collapsing.

` money_multiplier_chart.png

Will the Fed’s QE strategy lead to inflation? In the short-term, no. The money multiplier is falling because the economy is in a nasty recession alongside a serious credit crisis. In this environment, the surge of high powered money will not cause prices to rise.

Prices can drop in a recession (deflation) because the demand for goods and services falls with rising unemployment and declining income. But the 2008 recession is accompanied (or partially caused) by a credit crisis that induces banks to hoard the new base as excess reserves; this adds to the deflationary pressures. If deflation were to become embedded into consumer and firm expectations, then the macroeconomy could be facing a severe problem. So for now, and until the economy emerges from its recession, QE will not lead to inflation.

But what happens when the economy rebounds? Inflation becomes a serious risk if the Fed does not extract the high powered money. If the Fed gets it wrong, or its timing is off, then the money supply will rise quickly as banks start to lend more freely, and inflation results.

In the US’ case, I see the Fed getting it wrong as a serious risk to price stability (rising inflation). American consumers are not savers and love to spend; and although some suggest that the American saving behavior has changed, the evidence is far from concrete. Unless saving rises permanently – the economy transitions to a world where consumption is less than 70% of GDP – consumers will be more than happy to swoop up the new bank lending and spend that new easy money.

Originally published at the News N Economics blog and reproduced here with the author’s permission.

51 Responses to “All of the buzzwords in one post: quantitative easing, inflation and printing money”

mike ..AustraliaNovember 30th, 2008 at 5:09 pm

Fantastic to see that more articles about this subject of “frational reserve”, “high powered money” and the like are being explained in this timely way……..This article is the absolute best i have seen so far.Informative and not coloured with emotion in a really refreshingly composed way…..A delight to read.Since i consider myself a student, i want to have the best and clearest material about this almost esoteric aspect of money and its workings…Thankyou kindly for your good work!!

kumarFebruary 6th, 2009 at 12:37 pm

nice article…if you could relate this analysis to the “velocity” of the money as well, maybe it will help understand the topic better…

RickApril 1st, 2009 at 9:54 pm

Well written article that addresses part of the looming problems. Would be nice to have a new version with explanations on what one should do now if one believes in this scenario. If inflation is looming in 6 months, what should I do now?

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