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Will QE2 Lead to High Inflation?
By
James Kostohryz Nov 01, 2010 12:50 pm
Not necessarily, and those who promote this view adhere to an overly simplistic view of the quantity theory of money.
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Many financial commentators are promoting the notion that quantitative easing 2 (QE2) is a "money printing" scheme that will necessarily create high rates of inflation in the US in the future.
Typically, those that promote this view adhere to a dogmatic and simplistic view of the Quantity Theory of Money (QTM), by which increases in the supply of money necessarily lead to price inflation.
It's important to understand why this simplistic notion is false. Once this is comprehended, one can appreciate why a QE2 program of the magnitude currently being discussed is unlikely to create high rates of inflation.
QE2 Won't Necessarily Lead to a Major Increase in the Domestic Money Supply
Quantitative easing works primarily by the Fed purchasing bonds on the open market with money that it brings into existence. It's commonly believed that by this mechanism the central bank "creates money out of thin air." This manner of conceiving of the money creation process is incorrect. However, this isn't the relevant point. The relevant point is that the central bank's balance sheet expands.
What is meant when it's said that the Fed balance sheet expands? Fed assets expand by the value of the bonds purchased; liabilities expand in equal amount represented by federal reserve notes (US dollars) issued plus reserve deposits made by banks at the central bank.
Note that Federal Reserve notes plus central bank deposits constitute the monetary base (M0). In other words, for all intents and purposes:
Monetary Base (M0) = Fed Liabilities.
Here's the problem that must be understood: Fed liabilities (i.e. M0) don't constitute the money supply. In fact they only represent a tiny fraction of the total money supply. Furthermore, it's a demonstrable fact that in the past 30 years, changes in the Fed's balance sheet have had virtually no relation whatsoever to changes in broader measures of the money supply.
In a highly developed economy, the money supply expands and contracts as a function of the expansion and contraction of credit. For broader measures of the money supply to grow substantially, there must necessarily be a net expansion of credit in the overall economy. But in order for there to be a substantial expansion of credit, at least two conditions must be met (amongst others). First, there must be a substantial demand for new credit. Second, banks must be willing to expand their portfolio of credit by making substantial quantities of net new loans.
Now this is the crucial point to understand: Since neither of these conditions is present, QE2 is unlikely to produce an expansion of the broad money supply. QE merely causes an increase in M0. And as pointed out, an increase in M0, in and of itself, won't cause a substantial increase in the overall domestic money supply if there isn't a substantial expansion of credit in the domestic economy. As I've pointed out in prior articles such as Sobering Message From Fed's Kocherlakota: Fed Not as Powerful as Many Think, contrary to popular belief, the process of money creation is largely an organic or endogenous process in which the Fed is only one player. And right now, far from being a driver in the money-creation process, the Fed is in a reactive mode acting as a sort of "fire fighter" trying to prevent what would otherwise be a massive contraction in the money supply.
Please note that to this point, despite QE1 and the massive expansion of the Fed's balance sheet that this implied, various measures of the money supply, including M3 and MZM have actually contracted. See Is Fed Money Printing Leading to the Collapse of the US Dollar?
Increases in the Money Supply Don't Necessarily Lead to Inflation
For the sake of argument, let us assume for a moment that QE2 was implemented in such a manner and on such a scale that it actually led to a substantial increase in the broader measures of the money supply. As pointed out, this is unlikely. But let us indulge in this fantasy, just for fun. Would this lead to high rates of price inflation?
The short answer is: Probably not, unless the expansion provoked in the broad measures of the money supply were truly extraordinary (e.g. 25% or more).
The fact of the matter is that numerous studies have shown rather definitively that in highly developed economies, the money supply, whatever the definition, has little or no causal connection to inflation. Some studies show a very weak positive correlation; some studies show no substantial correlation; and quite a few studies show negative correlations. And with respect to causation, virtually nothing can be established.
Does this mean that money-supply statistics are of no use at all? No. But to the extent that they're useful at all, they are so for reasons that are quite different than most people are prone to think.
Perhaps the most useful way to think of measures of the money supply in a highly developed economy are as indirect and partial indicators of the effective demand for goods and services in the economy. The reason is clear: If there's no new demand for goods and services, there will be no net credit creation or new money creation. Similarly, without expansion of the money supply, the demand for credit as well as for goods and services will be constrained. The supply of money both enables and is enabled by the demand for goods and services in the economy. It's not a question of chicken or egg; they're essentially one and the same thing; you cannot have one without the other.
Thus, if we think of the money supply as a partial and indirect indicator of demand for goods and services, we can see that the rate of change in this variable could give us clues about the potential trajectory of inflation. For if all things remain equal, if the demand for goods and services rise, and aggregate supply remains constant, then prices will rise until aggregate supply and demand are equilibrated.
However, we must be careful in using monetary statistics when forecasting inflation. The changes in aggregate demand that may correlate positively with changes in the money supply represent only one side of the equation. In order to be able to properly forecast inflation, we have to know something about the other side of the equation: The supply of goods and services.
In an economy with low levels of resource utilization (labor and capital) characterized by high unemployment and high excess capacity, aggregate supply can expand relatively rapidly to meet rising demand thereby suppressing any increases in the general price level. Furthermore, the impacts of technology on rising productivity must be factored in. Finally, in a global market, trends affecting international supply must be considered.
In sum, a rise in the money supply will only be associated with inflation if a variety of other conditions on the supply side are met.
The Prospects for Inflation: International and Domestic Dynamics
As I've pointed out in various articles such as Ten Observations on the Risk of Rising Inflation, the supply of globally priced goods such as oil, metals, and food as well as other key commodities are relatively tight internationally. Furthermore, strong economic growth in resource-intensive developing economies is driving brisk demand for these commodities. Finally, the demand for credit is very high in capital-starved developing countries. Thus, combine tight supplies for key global commodities, brisk international demand, and an expansion of international credit that's being accommodated by US Fed-provided liquidity, and all of the factors are in place for price inflation in these globally priced products.
At the same time, most areas of the domestic US economy are characterized by overcapacity and high unemployment. Therefore an increase in the supply of money won't be accompanied by price increases in domestically priced areas such as housing and various services that comprise the lion's share of the US economy.
So how will all of this play out in terms of domestic aggregate price measures such as CPI?
In the US economy, well over 70% of total consumption is of non-tradable goods and services. Therefore, even substantial price increases in the internationally priced tradable area can only be expected to produce relatively modest, although non-negligible, overall increases in measures of aggregate prices such as CPI.
Conclusion
An analysis of purely domestic factors would suggest that a QE2, of the magnitude currently being contemplated, will be incapable of producing substantial price inflation in the US. Under current economic conditions, increases in the monetary base (M0) won't produce substantial increases in broad measures of the money supply due to the low demand for credit in the US. And in any event, under current conditions, increases in the money supply won't necessarily provoke inflation due to low domestic resource utilization (labor and capital).
However, if we broaden our focus to incorporate international dynamics, we can see that QE2 could drive an expansion of international credit which would "accommodate" developing country growth. This dynamic will tend to drive demand for resources such as oil, metals, and food in a context of tight international supplies.
The resulting commodity price inflation will clearly have an impact on the US. However, the impact, while not negligible, will be relatively modest due to the fact that internationally priced tradable products have a relatively low weighting in measures of aggregate pricing such as PPI and CPI.
Typically, those that promote this view adhere to a dogmatic and simplistic view of the Quantity Theory of Money (QTM), by which increases in the supply of money necessarily lead to price inflation.
It's important to understand why this simplistic notion is false. Once this is comprehended, one can appreciate why a QE2 program of the magnitude currently being discussed is unlikely to create high rates of inflation.
QE2 Won't Necessarily Lead to a Major Increase in the Domestic Money Supply
Quantitative easing works primarily by the Fed purchasing bonds on the open market with money that it brings into existence. It's commonly believed that by this mechanism the central bank "creates money out of thin air." This manner of conceiving of the money creation process is incorrect. However, this isn't the relevant point. The relevant point is that the central bank's balance sheet expands.
What is meant when it's said that the Fed balance sheet expands? Fed assets expand by the value of the bonds purchased; liabilities expand in equal amount represented by federal reserve notes (US dollars) issued plus reserve deposits made by banks at the central bank.
Note that Federal Reserve notes plus central bank deposits constitute the monetary base (M0). In other words, for all intents and purposes:
Monetary Base (M0) = Fed Liabilities.
Here's the problem that must be understood: Fed liabilities (i.e. M0) don't constitute the money supply. In fact they only represent a tiny fraction of the total money supply. Furthermore, it's a demonstrable fact that in the past 30 years, changes in the Fed's balance sheet have had virtually no relation whatsoever to changes in broader measures of the money supply.
In a highly developed economy, the money supply expands and contracts as a function of the expansion and contraction of credit. For broader measures of the money supply to grow substantially, there must necessarily be a net expansion of credit in the overall economy. But in order for there to be a substantial expansion of credit, at least two conditions must be met (amongst others). First, there must be a substantial demand for new credit. Second, banks must be willing to expand their portfolio of credit by making substantial quantities of net new loans.
Now this is the crucial point to understand: Since neither of these conditions is present, QE2 is unlikely to produce an expansion of the broad money supply. QE merely causes an increase in M0. And as pointed out, an increase in M0, in and of itself, won't cause a substantial increase in the overall domestic money supply if there isn't a substantial expansion of credit in the domestic economy. As I've pointed out in prior articles such as Sobering Message From Fed's Kocherlakota: Fed Not as Powerful as Many Think, contrary to popular belief, the process of money creation is largely an organic or endogenous process in which the Fed is only one player. And right now, far from being a driver in the money-creation process, the Fed is in a reactive mode acting as a sort of "fire fighter" trying to prevent what would otherwise be a massive contraction in the money supply.
Please note that to this point, despite QE1 and the massive expansion of the Fed's balance sheet that this implied, various measures of the money supply, including M3 and MZM have actually contracted. See Is Fed Money Printing Leading to the Collapse of the US Dollar?
Increases in the Money Supply Don't Necessarily Lead to Inflation
For the sake of argument, let us assume for a moment that QE2 was implemented in such a manner and on such a scale that it actually led to a substantial increase in the broader measures of the money supply. As pointed out, this is unlikely. But let us indulge in this fantasy, just for fun. Would this lead to high rates of price inflation?
The short answer is: Probably not, unless the expansion provoked in the broad measures of the money supply were truly extraordinary (e.g. 25% or more).
The fact of the matter is that numerous studies have shown rather definitively that in highly developed economies, the money supply, whatever the definition, has little or no causal connection to inflation. Some studies show a very weak positive correlation; some studies show no substantial correlation; and quite a few studies show negative correlations. And with respect to causation, virtually nothing can be established.
Does this mean that money-supply statistics are of no use at all? No. But to the extent that they're useful at all, they are so for reasons that are quite different than most people are prone to think.
Perhaps the most useful way to think of measures of the money supply in a highly developed economy are as indirect and partial indicators of the effective demand for goods and services in the economy. The reason is clear: If there's no new demand for goods and services, there will be no net credit creation or new money creation. Similarly, without expansion of the money supply, the demand for credit as well as for goods and services will be constrained. The supply of money both enables and is enabled by the demand for goods and services in the economy. It's not a question of chicken or egg; they're essentially one and the same thing; you cannot have one without the other.
Thus, if we think of the money supply as a partial and indirect indicator of demand for goods and services, we can see that the rate of change in this variable could give us clues about the potential trajectory of inflation. For if all things remain equal, if the demand for goods and services rise, and aggregate supply remains constant, then prices will rise until aggregate supply and demand are equilibrated.
However, we must be careful in using monetary statistics when forecasting inflation. The changes in aggregate demand that may correlate positively with changes in the money supply represent only one side of the equation. In order to be able to properly forecast inflation, we have to know something about the other side of the equation: The supply of goods and services.
In an economy with low levels of resource utilization (labor and capital) characterized by high unemployment and high excess capacity, aggregate supply can expand relatively rapidly to meet rising demand thereby suppressing any increases in the general price level. Furthermore, the impacts of technology on rising productivity must be factored in. Finally, in a global market, trends affecting international supply must be considered.
In sum, a rise in the money supply will only be associated with inflation if a variety of other conditions on the supply side are met.
The Prospects for Inflation: International and Domestic Dynamics
As I've pointed out in various articles such as Ten Observations on the Risk of Rising Inflation, the supply of globally priced goods such as oil, metals, and food as well as other key commodities are relatively tight internationally. Furthermore, strong economic growth in resource-intensive developing economies is driving brisk demand for these commodities. Finally, the demand for credit is very high in capital-starved developing countries. Thus, combine tight supplies for key global commodities, brisk international demand, and an expansion of international credit that's being accommodated by US Fed-provided liquidity, and all of the factors are in place for price inflation in these globally priced products.
At the same time, most areas of the domestic US economy are characterized by overcapacity and high unemployment. Therefore an increase in the supply of money won't be accompanied by price increases in domestically priced areas such as housing and various services that comprise the lion's share of the US economy.
So how will all of this play out in terms of domestic aggregate price measures such as CPI?
In the US economy, well over 70% of total consumption is of non-tradable goods and services. Therefore, even substantial price increases in the internationally priced tradable area can only be expected to produce relatively modest, although non-negligible, overall increases in measures of aggregate prices such as CPI.
Conclusion
An analysis of purely domestic factors would suggest that a QE2, of the magnitude currently being contemplated, will be incapable of producing substantial price inflation in the US. Under current economic conditions, increases in the monetary base (M0) won't produce substantial increases in broad measures of the money supply due to the low demand for credit in the US. And in any event, under current conditions, increases in the money supply won't necessarily provoke inflation due to low domestic resource utilization (labor and capital).
However, if we broaden our focus to incorporate international dynamics, we can see that QE2 could drive an expansion of international credit which would "accommodate" developing country growth. This dynamic will tend to drive demand for resources such as oil, metals, and food in a context of tight international supplies.
The resulting commodity price inflation will clearly have an impact on the US. However, the impact, while not negligible, will be relatively modest due to the fact that internationally priced tradable products have a relatively low weighting in measures of aggregate pricing such as PPI and CPI.
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