Must “Quantitative Easing” End in Inflation?

Inflation, Money Supply, & Quantitative Easing

Since the financial crisis of 2007-08 the term “quantitative easing” (QE) has been thrown around by politicians and economists alike. The media have gone as far to label it as “printing money”. Governments have been pursuing monetary policy with the aim of encouraging growth. Conventional policy such as the manipulation of interest rates has been ineffective already reaching record rates between 0.5% and 1%. As a result central banks have turned to QE in an attempt to encourage borrowing and spending. However, it is maintained that while pursuing economic growth there is an inflation target of 2%. Through expansionary monetary policy QE should end in inflation, in regards to the short-term. In the long run there are two central theories that can be taken into consideration Keynesian & Monetarist. In addition, there is the “Quantity Theory of Money” which suggests that there is a directly proportional relationship between inflation and money supply.

It is first imperative to understand what is meant by QE and inflation in order to establish their relationship. QE can be simply defined as the “introduction of new money into the money supply by a central bank”. This is done by purchasing government securities, debt or other securities from the market. The monetary aim of this policy is to encourage borrowing by consumers and businesses in order to create more economic activity to spur on growth. Inflation can be defined as the “sustained increase in the price level of an economy”, and it is measured most commonly by the Consumer Price Index (CPI) which measures the change in prices of a basket of goods. An integral factor in establishing the relationship between QE and inflation is money supply. This was clearly shown during and after the financial crisis through the Troubled Asset Relief Program (TARP) which is the direct injection of liquidity into the market.

Money supply can be manipulated through QE, and this has two effects. The first effect is the weakening of that particular currency on the basis of supply & demand. The second effect is that there is increased liquidity which would promote economic activity. This in theory would make countries’ exports more competitive and drive down the cost of borrowing for consumers. What is unique about QE is the manner in which the money supply is increased. Central banks buy long-term government debt and other asset/mortgage backed securities from commercial banks in order to increase their reserves so they could increase lending. In this is the hope that by increasing their cash reserves there will be a “trickle down” effect to consumers.

In order to establish a sound understanding of QE an example such as Argentina in the 1980s can be employed. The country had experienced various economic difficulties, but the crisis during the 1980s exhibited how direct government control of money supply resulted in chronic inflation. The government attempted to both restrict and increase money supply, at times causing inflation to reach peaks of an annual rate of 1000%. In addition, debts had to be repaid in hard currency, so money created went into buying foreign currency thereby monetizing the debt. This led to the weakening of the Argentinian peso and a sustained high rate of inflation. What should be noted was that the government was printing money and not using QE, which had an immediate inflationary response. In 1983 the government introduced the new peso in an attempt to reset the currency, but the weakness of the Argentinian economy through the illiquidity of the money supply led the country back into inflation.

The Argentinian economic crisis is an example of the inflationary trap that can be caused by government involvement in money supply controls.Japan is an example where QE was first used. The central bank created electric money in order to purchase short and long-term government debt from commercial banks in the hope of creating inflation. The Bank of Japan in 2001 concluded that QE is ineffective in regards to targeting inflation. Japan is a unique example as a result of chronic deflation, but it presents two theoretical approaches. It is unknown whether QE was ineffective because of the initial gradualist approach rather than “shock therapy” or that the manipulation of the money supply in regards to targeting inflation was only artificial. Japan has currently embraced aggressive quantitative easing under Shinzo Abe, but this brings into question whether the creation of negative real interest rates will actually increase the liquidity of the money supply. Furthermore, it raises the issue of crowding out and whether or not this will actually stimulate aggregate demand in order to achieve inflation.

Modern Results of Quantitative Easing & Money Supply Controls

Currently, QE is not abiding by “textbook” theory whether it is Keynesian or Monetarist, but this may be a result of the condition in which it is being implemented. Current estimates for inflation put the United States at 2% and the United Kingdom at 2.8%. Both have been rigorously using QE in order to encourage economic growth. Two things are currently evident – both countries are struggling to create economic growth, and that inflation is not dramatically increasing. Acclaimed economist Joseph Stiglitz said that:

“Stimulus measures carried out by the Federal Reserve, the European Central Bank and other monetary authorities won’t fuel the inflationary pressures that many have feared, but they also won’t bring the desired recovery and growth”

This can be explained by the manner in which QE is carried out. In the case of Argentina the government was manipulating the money supply through the printing of money. Currently central banks are purchasing long-term debt instruments and asset backed securities. Through this the central banks have raised the cash reserves of commercial banks to promote lending. After the financial crisis this was done partly in order to bailout the banks, and to ensure the repeat of the Great Depression does not occur. Nevertheless, the continued QE of this form continued to cover the balance sheet of those banks and fortify their cash reserves. The evidence for this emerges from the bursting of the housing bubble during the financial crisis, where the commercial banks held purely toxic assets as a result of the sub-prime mortgages.

The monetary aim of QE was for banks to make borrowing easier for consumers and businesses in order to create the desired economic activity. Arguably, QE has not achieved its purpose. After the financial crisis banking institutions began to cover the disparity in their balance sheets through the money created. Before the crisis banks offered high leverage on a variety of assets, meaning that the majority of the funding for the assets was through debt rather than equity. To give an example scenario a developer wants to purchase a building. The developer brings partial equity and asks for a greater amount of debt when applying for the financing from the bank. However, the bank is still willing to take the risk and provides the debt for the asset, resulting in a thinly capitalised asset. In essence, the bank is the outright owner of the asset, and when the financial crisis ensued the value of these assets was wiped off. So if the building was worth £1bn and the bank provided £900m of debt, while the post-crisis value of the building was £500m there is a balance sheet disparity of £400m. Banks allocated this as “tranches” which are collateralized mortgage obligations that can be configured for varying levels of exposure, which were dictated by the banks. QE helped the banks cover this disparity by covering the debt of what became toxic assets. This goes to explain why the first round of QE after the financial crisis did not end in inflation, as there was no increase in economic activity but the re-organisation of balance sheets.

Quantitative Easing in the United States

Still today there is a considerable degree of QE that is being implemented, and the banks’ balance sheets have been sorted out. So why is there no rapid increase in inflation? Central banks such as the Federal Reserve are still purchasing long-term government and corporate debt, but the money supply has become inactive within the economy – the “trickle down” is not occurring. The money supply is increasing but banking institutions keep the cash in their reserves, so do large corporations. This is demonstrated by the commercial banks willingly going beyond their reserve requirements (“Reserve Requirement” is the minimum amount of deposits and notes that a commercial bank must hold; this can be employed in the use of monetary policy as it can affect liquidity). Before the crisis financial institutions were too willing to take up high risk assets, but now as a result of the crisis there is a lack of risk being taken and also a lack of investment into long-term assets. Both banks and corporate institutions are favouring short-term tactical assets over long-term strategic assets. The short-term assets tend to not require the same level of capital to be raised, and this clearly demonstrates the lack of confidence in the economy but also a failure to employ comprehensive monetary policy.

The illiquidity of the money supply can be identified as a major factor in why QE is not resulting in inflation. This is demonstrated by considering the velocity of money, which dictates how much of the money supply is active within the economy (The issue with taking the velocity of money into consideration is our inability to establish an empirical value, and it is largely based on speculation. Therefore, we are unable to target market dynamics in the same way we can target inflation or growth). In the United States alone it is estimated that American corporations hold approximately $5Trn in cash reserves. This is a clear example of the lack of economic activity that must be facilitated for QE to result in inflation. The United States is desperately pursuing QE in the hope of boosting inflation to counteract the consistently strong dollar and to make exports more competitive. Krugman identifies that the Federal Reserve is pursuing QE with hope for inflation to occur so that:

“Potential home buyers will be encouraged by the prospect of moderately higher inflation that will make their debt easier to repay; corporations will be encouraged by the prospect of higher future sales”

This shows that QE is failing as a means to an end, as there is no subsequent inflation. The American government must create legislation to encourage corporations to pay out higher dividends or invest in R&D. This will aid in the utilisation of the vast cash reserves back into circulation; achieving the economic activity that QE was meant to ensure.

International Elements

A factor that is preventing QE from causing large rates of inflation is the denomination of foreign currencies. Presently the dollar maintains to be the favoured form of hard currency for central banks around the world. Consequently as more dollars are being produced there is a considerable foreign demand and this leads the money out of the domestic economy. Furthermore, this keeps the dollar strong in exchange rates making American exports less competitive. This culminates in a restriction of aggregate demand as a factor of the net exports component, making it desirable for the Federal Reserve to use QE to achieve a variety of economic goals. Yet, the globalised nature of the world economy is garnering unexpected outcomes from what can be considered as “textbook” economics.
The role of China has been questionable in regards to the relationship between QE and inflation. China is the largest holder of U.S. debt estimated at $1.5Trn, which presents a case that money created through QE, is quite simply leaving the country. Between the two economic superpowers a “too big to fail” relationship has occurred. If the U.S. economy was to default on its debt China would severely suffer. However the U.S. must continue its current monetary policies to encourage its biggest consumer of treasury bills (China). China on the other hand could threaten to begin selling of its American debt, entirely removing confidence there is in the dollar. This could lead up to a “run on the currency” which would result in unsustainable levels of inflation. The relationship between the two has had a considerable impact on money supply within the United States, and is a clear contributing factor in the lack of inflation as a result of QE.

European Economic Crisis

In Europe there is a different scenario. The European powers are arguing that austerity budgets are a must in this economic climate, yet the European Central Bank (ECB) continues to pursue QE. In Europe, however, this QE is simply covering the disparity in government’s balance sheets as a result of the various sovereign debt crises of Greece, Portugal, Spain, etc. So rather than QE encouraging economic activity to spur on growth, the created money is once more sinking into the black hole of covering toxic assets and arguably deficits driven by unsustainable welfare states. While targeting growth out of crisis there can be an inflationary response, and this is what QE is expected to achieve, yet the long-term results remain unknown. The money supply is constantly increasing, and interest rates are at 0.75% (at time of writing) and yet there is no evidence of increased borrowing. The banks are scared to take more risk, and the consumers lack confidence in their economies.

The monetary policy of QE can almost be identified as supply side because it has not created any demand, and this is instrumental in understanding why it is not resulting in inflation. The government has effectively setup what is needed for long-term sustainable economic growth through QE, but it has not created what can be coined as the “black start” ( The term black start can be associated as it is similar to how a car engine starts. Cars have a spark plug which ignites the engine, what can be noted is that the economy has no spark plug the money is there and so is the economic infrastructure but there is not anything to induce the utilisation of these factors). A factor contributing to QE not resulting in inflation is the lack of aggregate demand throughout Western economies. Currently the average unemployment rate across the European Union is at a staggering 12%, this clearly represents this lack of aggregate demand, and without this aggregate demand there is a restriction on economic growth in accordance to the simple aggregate supply and demand model. In order for the QE done to result in inflation it would be necessary to pursue demand side fiscal policy. This can take the form of government spending into structural investments such as road networks, railway lines, airports, and power stations. This would support the Keynesian argument for long run aggregate supply as there is spare capacity in the economy that is not being utilised, and showing that demand side policies do not always end in inflation as suggested by the monetarist model.

The relationship between QE and inflation is clear, through the link of money supply. It is clear that our modern situation where QE is not resulting in dramatic inflation is established through the lack of velocity in money. Bank, corporate and sovereign wealth funds’ cash reserves continue to increase and QE is only increasing the money supply but not making it active within the economy. In consideration to economic theory it should be simple – increase the money supply, cause inflation. But by using both historic and current examples and understanding it is clear that there is no causality. Therefore, it is evident that QE does not always end in inflation, and the modern economic climate is testament to that. Money has never been cheaper to borrow with rock bottom interest rates, and progressively increasing money supply, but there is no considerable rate of inflation. The question now is how long will this form of monetary policy be pursued, and what will be the long-term effects?

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