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“The complexities of cause and effect defy analysis.” ― Douglas Adams, Dirk Gently's Holistic Detective Agency
Why should the QE of the last 15 years be causing inflation only now?
In my post on Monday, I broached the question of whether the quantitative easing – QE – that kicked off in 2008 has in some way been responsible for the acceleration in consumer prices that began in 2021. This question will not be convincingly answered either by me or any time soon, but by experts in years to come – even then, there will no doubt still be disagreement. This, however, should not stop us thinking about the question today, particularly since monetarist theory says that inflation is inextricably linked to the money supply.
There are many aspects to QE and many more ways of explaining it, but the key immediate result of it is to push huge excess reserves into commercial banks, increasing their capacity to lend. Bank lending ordinarily is restricted by, among other things, the reserve requirement ratio (RRR) – if banks were required to reserve 100% of loans their lending capacity would be severely restricted.
However, increasing total reserves - required plus excess - way above what is required to be held renders the RRR redundant – indeed, in the US, it was abandoned – set to zero - on 24 March 2020. Although the RRR had been inconsequential since 2008, the Fed finally got round to formalising its irrelevance. Perhaps it felt the need to send a message to the banks in the face of Covid-19 that their capacity to lend was being increased from several orders of magnitude higher than current loan book based on prevailing RRR to infinity – the money multiplier, a measure of how much broad money can be created from one unit of narrow money, is equal to 1 divided by the RRR. An RRR equal to zero means...
Monetarist theory says that inflation will rise if the money supply rises faster than national income. This is simply about supply and demand - money supply represents the demand for goods and services, national income or production the supply of them. Yes, calling money supply demand is confusing.
However, money supply in this context refers to broad money associated, largely, with commercial bank lending, not narrow money i.e., the monetary base/reserves. The reason that the huge QE-related increase in the monetary base was not accompanied by rising inflation, at least until very recently, was that bank lending kept pace with national income/production. In other words, lending largely went towards increasing the quantity of new goods and services – new capacity - rather than lending that chased existing goods and services. This of course is as it should be.
That said, it could be argued that the low interest rates induced by QE, as well as lending to purchase existing assets - mortgages and margin lending, for example – led to asset price inflation that might have spread to the broader economy i.e., goods and services. This, however, is not what happened. Consumer price inflation stayed very low. Until recently, that is.
There is little doubt that the high inflation in recent months is, to a significant degree, the result of supply issues, whether those associated with Covid-19 or with Ukraine. Also, in the face of demand that by 2021 had recovered from the shock of the pandemic, Biden’s $1.9 trillion dollar stimulus just added fuel to the fire, putting even more money in consumers’ pockets, thus increasing demand further. The combination of continuing supply issues and souped-up demand was toxic in terms of the effect on consumer prices. However, how might the QE of the previous 13 years have played a role?
It is hard to discern a causation. If QE had brought down interest rates as theory suggested it should, that might have increased bank lending which could possibly have put upward pressure on consumer prices. But QE is designed to battle deflation and thus ultimately to increase interest rates, not lower them. And anyway, there is little evidence of banks using their increased lending capacity irresponsibly. After all, it is in banks’ interest to get paid back.
Perhaps the main story in relation to QE’s effect on inflation is yet to be told. As noted on Monday, the difference between supposedly non inflationary QE and inflationary money printing is simply whether the assets that a central bank buys eventually get sold back to the market, a process known as quantitative tightening, or whether they never get sold i.e. excess reserves are permanent. If commercial banks come to believe that their current huge excess reserves will at some point be taken away from them and therefore that they cannot “lend them out”, they won’t.
The question therefore as to whether QE is now or will be inflationary is: how credible are central banks’ assertions that they will shrink their balance sheets?
Below is the chart from my Monday post. It appears that, at least in the case of the world's most important central bank, the Federal Reserve, balance sheets have never been shrunk on anything other than a short-term basis. If, therefore, banks at some point begin to believe that their huge excess reserves are permanent, effective lending supply would be vastly increased. Thus, to constrain actual lending enabled by this greater supply, demand would need to be curtailed, via recessions and/or higher interest rates.
Source: Federal Reserve
If, on the other hand, central banks do shrink their balance sheets, flooding the market with bonds, this would likely lead to higher interest rates and...recession. Central banks really are stuck between a rock and a hard place.
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.
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