Note on quantitative easing

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Note written by an ‘in paradigm’ associate:

Growth in the size of the Fed’s balance sheet indicates that it is acting as a financial intermediary, but it doesn’t say anything useful about real economic activity or prospects for inflation. Even when the Fed buys Treasury debt from the private sector in return for cash, it is only substituting one financial claim on government for another of identical nominal value. This transaction doesn’t change the net financial assets of the private sector – so there is no obvious economic impact. Similarly, the Fed can encourage or even require banks to hold more and more excess reserves, but to what end ? Bank lending is not constrained by a lack of reserves, it is limited by capital ratios and the opportunity set for profitable lending. In this context, reserve growth increases gross balance sheets, but has no economic consequences.

What might be said about quantitative easing (QE), is that the Fed has to bid up bond prices (forcing yields down)in order to acquire Treasuries in the secondary market. At the margin, this has the potential to induce changes in portfolio preferences and push investors into more risky assets. So, QE might have some second order effects on financial assets prices, but still no logical or direct connection to generalized price inflation.

Some potential causes of inflation going forward might include sustained fiscal stimulus of sufficient proportion to more than offset the spontaneous decline in private sector demand that we are witnessing. If this were to use up existing capacity, then the probability for inflation goes up. Furthermore, even before we reach full capacity domestically, some of the growth in aggregate demand will leak overseas. Many of our imports have low elasticities and their prices could rise quickly. The most obvious example is crude oil. This would result in upward pressure on reported inflation even with broader economic growth below trend. In other words, a partial recovery of aggregate demand without energy policy reform could be inflationary.

I would hasten to add that none of this is original thinking and most of it is common sense. I found it odd that so many of the brilliant and successful people that you assembled last week relied on vague notions of “monetarism” or “Keynesianism” to frame their views and reverted to jargon rather than analysis to argue their points.