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The Federal Reserve has monetised a few trillion dollars of bonds over the
past seven years without creating much in the way of what most people call
"inflation" (a rise in the general price level). How could this
happen?
One popular explanation is that the Fed's Quantitative Easing (QE) adds to
bank reserves, but not the economy-wide money supply. According to this line
of thinking, the 'money' created by the Fed to purchase bonds remains trapped
in reserve accounts at the Fed. However, this explanation can be immediately
eliminated, because as previously
explained every dollar of QE adds one dollar to bank reserves at the Fed
AND one dollar to demand deposits within the economy. The fact is that the
economy-wide money supply is now a few trillion dollars larger thanks to the
Fed's QE.
A second explanation is that QE isn't "inflationary" because it
involves the exchange of one cash-like instrument for another. This
explanation can also be immediately eliminated due to the fact that it
mistakenly conflates two very different things - money and debt securities.
If you don't understand the difference, try buying something with a T-Bill.
You should then understand. Also, more information on this particular issue
can be found in my 9th
May post at the TSI Blog.
As an aside, QE is not only NOT an exchange of one cash-like instrument
for another, it involves increasing the amount of cash in the financial
system and simultaneously decreasing the amount of financial assets that can
be bought with cash. That is, it results in more cash 'chasing' fewer assets.
A third explanation is that the increase in the money supply stemming from
the Fed's QE has been offset, in terms of effect on the general price level,
by a decrease in the velocity of money. This is yet another explanation that
can be eliminated, because changes in "money velocity" never
explain anything. The reason is that money velocity (V) is nothing more than
a fudge factor that makes one side of the tautological and
practically-useless equation of exchange (MV = PQ) equal to the other side.
It exists in academia, but not in the real world. For more information on the
irrelevance of money velocity, refer to my 10th
June post at the TSI Blog.
Having eliminated three of the fatally-flawed explanations for why the
Fed's gargantuan QE hasn't yet led to problematical "price
inflation", I'll now provide two explanations that make some sense.
First, for decades prior to 2008 almost all of the US economy's new money
was created by commercial banks (commercial banks can loan new money into
existence and they can also monetise securities). As a result, the first
receivers of the new money tended to be within the 'general public' (home
buyers/sellers, private businesses, etc.). However, since August-2008 almost
two-thirds of all new money has been directly created by the Fed. This means
that the first receivers of most of the new money were bond speculators, and
that the second, third, fourth and fifth receivers of the new money were
probably bond speculators or stock speculators. In other words, rather than
being trapped in reserve accounts at the Fed as some people have mistakenly
asserted, it is likely that a lot of the new money has effectively been
trapped within the financial markets. It will eventually leak out into the
'real' economy, but due to the way the money was created/injected there has
been a much longer-than-usual delay between the money creation and the
inevitable effects on everyday prices.
Second, it's important to understand that even if it were possible to come
up with a single number that reliably reflected the actual change in the
economy-wide purchasing-power (PP) of money, this number would not tell us
the "inflationary" effect of a change in the money supply. The
reason is that to know the effect on money PP of a change in the money supply
you have to know what would have happened to PP in the absence of the
money-supply change.
For example, let's assume for the sake of argument that there is a
consumer price index (CPI) that reliably indicates the change in the general
price level. In our hypothetical example, the CPI would have fallen by 10%
over a certain period, but due to money-pumping by the central bank the CPI
increases by 2%. In this case the "inflationary" effect of the
central bank's money-pumping is not a 2% increase in the CPI, it is a 12%
increase in the CPI (the difference between what happened and what would have
happened).
Taking into account the high private-sector debt levels that existed in
2008 and have persisted to this day, it is not hard to imagine that in the
absence of the Fed's money creation there would have been a sizable decline
in the CPI rather than a moderate increase. The "inflation" caused
by the Fed's QE is the difference between the decline in the general price
level that would have happened and the rise in the general price level that
did happen.
In conclusion, there are two main contributors to the lacklustre
performance of the "general price level" over the past few years.
First, unlike in earlier cycles a lot of the money created during the current
cycle was injected directly into the financial markets. Second, it's likely
that there would have been significant "price deflation" in the
absence of the money-pumping.
http://tsi-blog.com/blog/blog-default/
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