Scrutiny of inflation risk from various different perspectives helps frame what is a very complex issue. In this analysis, the Fed’s quantitative easing (QE) program is examined, as considerable misunderstanding surrounds its economic impact.
Insanity has been defined (as often misattributed to Albert Einstein) as the act of repeating the same actions and expecting different results. This definition comes to mind when pundits suggest that monetary stimulus through large scale asset purchases (also known as QE) will eventually lead to inflation. These same concerns were raised by prominent economists and money managers back in 2010 in an open letter to the Fed. They warned that significant asset purchases would eventually lead to the decline in the dollar and a rise in inflation. Since then, the dollar moved higher not lower, and the Fed has yet to attain its modest 2% inflation target.
The Fed Restarts Quantitative Easing
Today, the Fed’s asset purchases are expected to exceed what it did in the last cycle, and over a much shorter period of time. From the end of 2007 the Fed’s balance sheet increased by approximately $3.5 trillion over the course of seven years. To date in 2020 the Fed has tacked on an additional $3 trillion. Many expect this to rise by another $2-3 trillion by the end of 2021.
Sources: Bloomberg, U.S. Federal Reserve
Money: How Is It Created?Typically money is created through banks, not the Fed. When you get a $500,000 mortgage to buy a home through a bank, the bank creates an asset representing the mortgage (money you owe the bank) and a liability of cash in your name (money it owes you). No one supplies the money to the bank, it literally comes out of a bookkeeping entry. It is what makes banks unique as they have the license to create money. That transaction causes money supply to increase by $500,000. And that money is used to purchase something – a good or a service – raising GDP. Debt created outside of the banking channel does not increase money supply. When a firm issues $20 million in bonds, for example, the money for this comes from investors. No new money is created in the transaction.
How the Fed Creates MoneyHistorically, the Fed bought and sold Treasuries to help manage short term interest rates (called open market operations). These transactions represented a very small portion of the change in money supply. Historically, nearly all money creation arose through the banking channel. This changed in 2008. After taking short-term rates down to zero, the Fed began a QE program to buy longer term maturity bonds, seeking to bring those yields down and encourage borrowing. Now in 2020, the Fed has aggressively revisited these so called large-scale asset purchases, announcing it would purchase an unlimited amount of securities and eventually widen the purchase net to even include below-investment-grade bonds and municipal securities. The impetus this time was not so much to bring long-term interest rates down as it was to insert liquidity into the markets and loosen credit conditions to help companies in need of cash get access to the debt markets.
Is the Fed creating money to purchase these securities? This seems like an obvious yes, but the answer is not that definitive. The Fed buys most of its securities through primary dealers.1 The primary dealer delivers the security to the Fed and the Fed creates a credit to its cash reserve account. Note that the primary dealer’s balance sheet value doesn’t change, as the security was exchanged for cash reserves. So from the perspective of the private sector, no new money has been created. That is very different from the money that banks create through lending. So while yes, the Fed is creating money to purchase securities, it is sitting on the Fed’s balance sheet, and cannot be spent. By taking securities out of the marketplace QE resulted in raising the price of other financial assets (not the price of goods and services). There are secondary effects that are supposed to help the economy such as through more borrowing due to lower interest rates. In the last cycle, the secondary effect was hindered as banks were reluctant to lend (primarily because of factors surrounding the QE program, but also due to bank regulations).
As mentioned earlier, the Fed historically would buy and sell securities to help set the Federal Funds rate. With the Federal Funds rate already set at zero, if the Fed were to flood banks with excess reserves through QE purchases, it would lose control of the Federal Funds rate which would likely fall into negative yields. To prevent this, it needed to separate interest rate policy from its balance sheet. This was done by paying interest on excess reserves. This interest on excess reserves compensated the banks for holding them. Reserve balances do not influence bank lending (as is widely believed); market conditions spur lending. By flattening the yield curve and lowering credit spreads the Fed’s QE program reduced the lending profit potential for banks. In the last cycle, stocks and bonds saw strong returns, yet economic growth was the weakest on record. The QE program was a contributing factor to this outcome; should we expect this same result going forward?
Will It Be Different This Time?
Consider the data. Currently the Fed’s widest measure of money supply is M2 which includes currency and cash equivalents. Money supply has become very difficult to measure due to the proliferation of financial products that may or may not have the characteristics of money, but it is all we have. By this admittedly rough measure, M2 suggests that money supply has increased by approximately $3 trillion year-to-date. This is nearly equal to how much money the Fed has created on its balance sheet. That would suggest that no net new bank lending has occurred.2 How can this additional Fed money be inflationary if it is inaccessible? Without bank lending, money supply in the private sector is not growing. And if the Fed follows through with yield curve control measures, a continued flat curve would pose as a disincentive to bank lending.
Sources: Bloomberg, U.S. Federal Reserve
Looking through the lens of money creation, at this point it seems unlikely that the Fed’s QE program presents a significant inflationary risk. That is a positive for the markets. Though as mentioned at the outset, inflation is complex with many drivers, of which money supply is but one. Future discussions will consider other factors such as fiscal stimulus and whether the Fed is monetizing this debt as well as elements influencing the supply and demand for goods and services.
1 A primary dealer is a pre-approved bank, broker/dealer, or other financial institution that is used to implement monetary policy.
2 Through its different lending facilities, the Fed has done some direct lending, though it currently amounts to a small portion (10%) of the increase in their balance sheet.
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