Thursday, May 5, 2011

QE, inflation and walking under ladders. What these things have in common.

We've heard many so-called experts say that Quantitative Easing causes inflation because the Fed is "pumping the economy with money."

We know this is not true and that whole notion has been debunked here many times.

However, just from the standpoint of common sense one should understand that there is no connection between QE and inflation.

Why would someone who has been sitting in a safe and secure gov't bond suddenly turn around and invest those proceeds in something as speculative as commodities? Maybe on the margin some of that is going on, however, it is not going on in any size that would cause the runnups in materials prices that we have seen.

Moreover, it is important to remember that the Fed conducts monetary operations (buying and selling of securities) with the primiary dealers and it is the primary dealers who sell to the Fed. This makes them "short" and since they need inventory at all times to meet the demand from their customers, they turn right around and cover those shorts by buying government bonds again in the next auction or whatever. (BTW, that's why the auctions go off so well all the time. The Fed has provided the funds.)

The money going into commodities right now is cash that investors and hedge funds have been sitting on and they put it to work ON THE BELIEF that QE causes inflation. You can equate it to the behavior of people walking around ladders rather than under them, because they believe that walking under them is bad luck.


ATR said...

another interesting perspective on QE2 from the MMT camp. similar to many other posts in the MMT blogosphere, but the point about a mass swap of risk free assets for highly speculative investments is a nice addition to the discourse.

apj said...

Mike, that's one element ('fear' of inflation, even if a massive misconception). The other is that QE is, by definition, a promise to keep rates low for a long time. Extended period language in Statements is therefore redundant. When you couple fearful markets fearful of inflation and the idea that the funding of your trade simply is a guaranteed, the risk rally is axactly what you get. The (soporifically slow) 2004 tightening was very similar in this regard, and didn't ecen have QE!

Tom Hickey said...

Interesting that Gross and PIMCO got caught up in inflationary exportations arising from QE — while Jeff Gundlach did not.

Philip said...

Hmm. Ok, so is there a financial institution (oh, I don't know, maybe *cough* Goldman Sachs *cough*) that is effectively getting the Fed to function like a "penny stock promoter" for commodities (especially oil and gold)? That is, the Fed (I'm assuming unknowingly but it could be knowingly) promotes a quantitative easing program, which doesn't do much but stoke the fear of inflation and cause people & institutions to buy gold and oil to protect themselves (that's the "pump"). Then, when the program ends, people slowly return to more normal expectations and these commodities return to a much lower price (the "dump").

Is that what we had in 2008?

This may sound cynical, but I have to wonder how many of our political leaders have assets under management with Goldman Sachs?

Tyler F said...

Mike, someone sent me a typical, and with popular perceptions, article from England's Daily Telegraph entitled "America's reckless money-printing could put the world back into crisis" (4/30/11). It's filled with the usual, scary inflationary and weak dollar rhetoric.

In it they seem to conflate monetary base and money supply. "America's base money supply – the bedrock of the world's reserve currency – has doubled in little more than two years."

Could you or Tom or somebody briefly explain, as best you can in layman's terms, the difference between the monetary base and the money supply and how you can have an increase in the monetary base but not in the money supply. I suppose in that answer will be how an increase in the monetary base is not inflationary.

Tom Hickey said...

It's money under a mattress v. money circulation. The monetary base in increase is an increase in bank reserves at the Fed. These reserves have to enter the economy to affect spending or they are essentially inert, like money under a mattress. They can only enter the economy two ways. Either demand for cash has to increase at bank windows or else banks have to create deposits by extending loans. Banks are not loaning because of lack of demand for loans by customers they consider credit worthy. Moreover, people and businesses do not care to borrow because of uncertainty due to intractable unemployment and other negative factors they see.

What this means is that there has to be a transmission mechanism from reserves (base money at the Fed) to the money supply circulating for spending. That transmission mechanism is credit, and credit has essentially dried up because consumers are stretched and not buying, so business is not spending on expansion in anticipation of increasing sales.

The Fed has an infinite supply of reserves, which are created with keystrokes. But even entering very large numbers onto the Fed's spreadsheet does nothing to get the money in the hands of either consumers for consumption or businesses for investment.

The problem is that the battery to start the transmission mechanism of lending is weak. That battery provides the "electricity" of effective demand that sends a signal to business to expand. That is why government must step in and charge the battery with enough of a deficit to offset demand leakage resulting from an increased desire to save/delever together with net imports.

The fact that lending is weak even with interest rates low shows that the threat is deflation rather than inflation. People and businesses are saving rather than borrowing, even at historically low rates.

Some of us have seen astronomically high interest rates in the '80's and now astronomically low rates presently.

Tyler F said...

Great. Tom, thank you!

Letsgetitdone said...

Very, very nicely written, Mike. Everyone who's worried about QE should read this.

Btw, what's the difference between the Fed providing the money so dealers can buy new debt at Treasury auctions, and the Government simply spending money without debt issuance?

Answer, the rich continue to collect their welfare in the form of interest payments. Let us have an end to welfare for the rich.

Letsgetitdone said...


Your answer to Tyler F. was very well put also. Perhaps you ought to promote that to a blog post and discuss it in the light of Matt Rognlie's concern about the base money supply's connection to inflation?