The Sky is Falling, The Sky is Falling...and QE2 is to Blame!

            The “sky is falling” inflation fears are a recurring theme nowadays thanks to a group of “inflationistas” running around screaming about runaway inflation and the imminent collapse of our economy. Any attempt to quell their fears with references to the CPI-U and BPP result in a unilateral dismissal of any index that contradicts the impending end of our currency. And who is the villain behind our impending doom you ask? "The Fed and its QE2 policy", say the inflationistas which has “printed” trillions of dollars in a misguided attempt to jump start our economy.

            There is no debating the existence of inflation within our economy a fact supported by both the CPI-U and the BPP. What is debatable is the runaway inflation (or hyperinflation) that the inflationistas say we are currently experiencing as a result of the second round of quantitative easing (QE2).The CPI and BPP report very modest levels of inflation but inflationistas retort that the CPI is a government manipulated index that clearly isn’t accounting for the inflationary effects of QE2 on our currency. After all how can you print trillions of dollars in new currency and not expect there to be inflation?

The fact that Japan, whose recent economic problems are very similar to the U.S.'s problems, used a quantitative easing policy through the early part of the century with no inflation (Japan continues to suffer deflation) should be an indicator that quantitative easing and inflation are not synonymous. However for the sake of argument lets dismiss the Japanese historical precedent and assume that Japan and the U.S. economic situations are too different to be relevant.

            Inflationistas are shocked to learn that the trillions that the Fed has reputably “printed” haven't been printed at all. Printing money is usually associated with the monetizing of a nation's debt (think Weimar Germany) which is not in fact what has occurred with QE2. The money was created electronically and credited to the accounts of those banking institutions that are members of the Federal Reserve system in a bond purchasing program.Combined with low interest rates the bond buying program was designed to increase liquidity at commercial banks and promote lending (credit easing) and thus start the recovery. The ultimate result of all of this is to reduce unemployment and maintain a very slow level of inflation.

Graph 2 Lending from Comm. Banks

Graph 1 Reserves Amounts

           However the money that was created and put on account for the banking industry to date hasn’t been used (similar to what occurred in Japan). Instead those funds are sitting on account at the Federal Reserve earning interest for the holders of said accounts. Apparently commercial banks have decided to either leave the reserve fund that are earning them interest or simply refrain from loaning the money and instead are putting it into short-term treasury bonds. To support these facts see graphs I and II. Graph I shows the reserve amounts sitting on account within the Fed for commercial banks and graph II shows the downward trend of lending. The slight up-tick in graph II during 2010 is most likely a result of QE2 efforts but the trend is downward again. (All Graph information provided by FRED)

           We have the part of the answer to this problem but cannot finish until we discuss inflation itself.

Inflation has many definitions but the most common states that inflation is a sustained rise in the price of goods and services over time. From my vantage point though this definition doesn’t show inflation’s true colors so I prefer the old adage inflation is “too much money chasing too few goods”. The key word here is “chasing” because the amount of money that you have in a given system is irrelevant if that money isn’t being spent “chasing” goods. The “chasing” portion is expressed as velocity of money and without velocity there can be no inflation.The importance of velocity can be easily illustrated.

Let’s suppose that the Fed electronically creates 200 trillion dollars and credits my account with that money. I go in, see the money but never spend it. The money supply has expanded dramatically but there hasn’t been any inflation because the money created isn’t chasing any goods. This is a demonstration of lack of velocity and reveals the true nature of inflation. You can expand a money supply dramatically but if that money isn't being spent chasing goods you end up with little to no inflation at all. Or even worse yet you end up with deflation (again reference Japan).

            If we recall graph 1 the money created by QE2 is sitting on account for the banking industry and combine that with graph 3 showing that money velocity is at a 20 year low the idea that we haven't entered a period of runaway inflation becomes highly probably and the CPI's and BPP's numbers plausible even if you are skeptic.

Graph 3 Velocity of the M2. Courtesy of Fed. Reserve.

  Referring back to the scenario above let us suppose that I decide to use that 200 trillion to pay off some old debts. I send 10 trillion dollars to 20 banks that I owe money and call it day happy that I no longer have debt. Worried about the current economic state and my job I decide it is best not to do anything but sit back and wait to see what happens. The banks receive the money I owed them and happy to have the debt paid off decide to call it a day and leave the money in their accounts to earn interest. Everyone has effectively de-leveraged themselves and has decided to no longer borrow or lend money. There has been limited turnover but very little in the way of velocity. No risk has been taken, no loans made, money borrowed so the trillions haven't made their way into the economy to chase goods.

            Based on the above facts and situations it is easy to understand why despite a considerable expansion of the money supply there hasn't been any severe inflation. Of course this doesn't remove the threat of inflation but it does help explain why the CPI-U and BPP's inflation numbers are at their current modest levels. As money velocity picks up and bank lending and consumer spending resume the Federal Reserve will be forced to combat inflation and remove liquidity from the system. There is a number of methods through which this can and will be accomplished that probably deserve a blog of their own.That said quantitative easing and inflation are not synonymous and both our current predicament and Japan's history demonstrate that effectively. In fact the best argument against quantitative easing is probably the fact that in Japan it did very little in the way of jump starting the economy and causing any inflation at all.