Download The effect of Quantitative Easing on inflation in the US

The effect of Quantitative Easing on inflation in the US
Benedykt Brzozowski
Introduction
When the recession following the subprime mortgage crisis hit the US economy, the Federal Reserve
introduced the policy of Quantitative Easing, purchasing assets in exchange for cash injections. Many
voices were raised that this policy could be rather unsuccessful and to make matters worse, dangerous
for the price level. As historically money creation used to lead to a high level of inflation, it should also
be the case this time. Nevertheless, it has been almost a decade since the policy was introduced and
not only the hyperinflation has not appeared, but also the Fed has barely managed to hike it to
the desired level of 2%. In my work I try to answer the question why was it the case, focusing on
a structure of the policy and behaviour of market participants. In my work I do not try to find the exact
effect of QE on inflation or GDP in numerical terms but rather to go through different aspects of QE,
analysing what might or should have happened and what actually happened and why.
In the first section, I describe the period prior to the implementation of the policy, using the Three
Equation Model1. I show the main features of the US economy, pointing which aspects led to the offequilibrium stance and how it can be modelled. Since this is not the main point of my analysis but
rather a tool used in order to show the general logic behind it, the modelling section is strongly
simplified. In the second section, I quickly summarise the policy of QE. In the third section, I am focused
on presenting different channels through which QE was expected to affect the economy, pointing
the wealth effect and the money injections as the ones mostly likely to have an adverse effect on
the price level. I use the Three Equation Model once again, to show the desired effect of each channel.
The next section is the main in my work, where I evaluate each channel’s effect on inflation. I give
the reasons for which QE is not directly inflationary in its structure but can become inflationary
indirectly. Furthermore, I show that it did not become too inflationary even indirectly in the US case
since market participants’ decisions were affected by several discouraging factors, some of which were
in the Fed’s hand. Consequently, the Fed’s policy seems to be more reasonable and harmless than
might had been considered by some before the implementation. Finally, in the last section, I try to
evaluate whether there are chances for the effects of QE on inflation still to appear and whether
the Fed has relevant tools to prevent this.
Before QE (the Three Equation Model)
In 2007 the bubble on the housing market burst, wiping out the equity of many homeowners, which
consequently led to the so-called subprime mortgage crisis. Not only demand for houses decreased
but also prices started falling on account of banks quickly selling the houses acquired as collaterals.
This accelerated the effect of wiping out the equity and caused even further drops in households’
wealth. In order to restore it, households needed to cut their consumption, which applied especially
to durables, obviously including the real estate (the IS curve shifts left from IS(0) to IS’(1) as C
decreases). Furthermore, highly leveraged financial institutions in the US were under the threat of
insolvency as the value of accounting for a high share of their equities securities tied to the real estate
market (mostly MBSs and CDSs) started falling rapidly. In September 2008 Lehman Brothers went
bankrupt, triggering an economic downturn with stock markets plunging, consequently firms
postponing their investment decisions and households cutting their consumption further because of
the lowered income expectations (further shift of the IS curve to the left to IS(1) as C and I decrease).
Worsened economic conditions also meant lower inflation expectations as market participants
1
The Three Equation Model used in this work with all its notations and logic is the same as in
W. Carlin & D. Soskice “Macroeconomics. Institutions, Instability and the Financial System” (2015)
included the oncoming recession into their predictions of economic activity. Finally, it is possible that
the potential supply has grown, reflecting accumulated capital from past investments from
the prosperity period, consequently leading to the even bigger output gap. (Ellis, 2009) (rightward
move of the equilibrium output, “the bliss point” moves from A to Z, consequently the MR curve shifts
to MR(1) and the PC to PC:π*(0). Now, including the deflationary shock mentioned above, the PC shifts
down as market participants expect inflation in the future period to be π(DS)). The US economy started
experiencing a recession (move to the point B). Faced with such a situation, the Federal Reserve
decided to cut the interest rate to the record low (Federal Funds Rate at 0.25%). However, this was
not enough as the Fed faced a problem of deflation trap, where lower bounds on nominal interest
rates prevent a central bank from reaching its optimal output and lead to further drops in inflation
expectations (to get to the desired point C’, the Fed is in need to set r=r’(1), which is unattainable due
to the ZLB. The lowest it could get is r(1), taking into account the new PC=PC(2). Thus, when the interest
rate is set, it only moves the economy to C, with the lower than expected level of inflation. It pushes
the PC downward to PC(3) in the following period. What is more, the minimum real interest rate level
goes up each period as inflation goes down, which compounds the deflationary effect). With the
decision of paying the interest on the banks’ reserves, the Fed was believed to had used all
conventional methods of monetary policy. Thus, it needed an another instrument that could enable it
to bring the economy back to equilibrium.
1. The Three Equation Model - before QE
Quantitative Easing
In the late November 2008, the Federal Reserve announced a policy of buying assets in return for newly
created money. This process consisted of purchases from the private sector in the secondary market
through the primary dealers. The Fed’s aims were mainly to rescue the financial institutions being at
the edge of insolvency and to close the output gap by boosting aggregate demand through lowering
the long-term interest rates and through a few other channels explained below. Throughout all
the rounds of the Quantitative Easing, the Fed has purchased about $1.75 trillion in Mortgage Backed
Securities and $2.3 trillion in long-term Treasuries (mostly 10-year notes), comparing to no MBSs and
$850 billion in Treasuries on its balance sheet as before the recession. The Fed announced decreasing
an amount of purchases, referred to as tapering, at the end of 2013 and officially closed
the programme in October 2014.
Summary of QE:




QE1 (12/2008 – 06/2010): $1.25 trillion in MBS, $300 billion in long-term Treasuries
QE2 (11/2010 – 06/2011): $600 billion in long-term Treasuries
Operation Twist2 (09/2011 – 12/2012): $400 billion in long-term Treasuries
QE33 (09/2012 – 10/2014): $85 billion monthly in long-term Treasuries, $40 billion monthly in
MBS
Possible transmission channels
1. Confidence
With introducing the unorthodox monetary policy, the central bank is believed to “do everything” to
reach its objective. Therefore, this should increase investors’ trust and anchor the expectation,
enabling the central bank to lead the economy along its chosen path, reducing the volatility of output
and inflation in the process.
2. Lower cost of borrowing
The yield curve is placed in the space with time to maturity on the x-axis and interest rate on the y-axis.
It is upward-sloping (in general) as investors demand higher interest rates for the long term on account
of higher opportunity cost and risk premia for uncertainty. By reducing the basic interest rate,
the central bank shifts down the curve and reduces interest rates of all maturities. The central bank’s
main focus is on lowering the long-term interest rates as these are the ones that count in terms of
loans and debt-financing, thus affecting the consumption and investment decisions. However, when
the nominal short-term interest rates hit the ZLB, the central bank needs to affect the long-term
interest rates indirectly by pivoting the curve. By purchasing long-term Treasuries (mostly 10-years
notes) and MBSs, the Fed was going to create extra demand for these assets, which would push up
their prices. Because of a specific structure of bonds, with yields inversely correlated to prices, it would
push down the yields and thus decrease the borrowing cost. Consequently, this could stimulate
economic activity since households would be more inclined to take loans, banks to lend more and firms
to issue new corporate bonds for a lower cost as well as to go into previously unprofitable investments.
As a result, economic activity should increase, raising inflation and reducing the output gap. According
to some, there is a danger of banks desperately seeking profits by lending to risky borrowers, which
may not only lead to another subprime mortgage crisis but also increase the stock of broad money
significantly. As a result of these two effects, the actual activity will not change the output that much,
however pushing the prices to very high levels (I will come back to this issue in “Money and market
liquidity”).
2
Operation Twist was a part of QE when the Fed was purchasing long-term Treasuries as a replacement
of the maturing short-term Treasuries instead of rebuying short-term notes as usual
3
QE4 considered as an extension of QE3, hence added together
3. Wealth Effect
Since investors see different assets as substitutes, a reduction in long-term yields on some assets
should also affect prices of the others. When relative returns on assets change, in this case lower
returns on purchased MBSs and Treasure notes, investors seek opportunities elsewhere, shifting
the demand to other assets such as corporate bonds and equities and therefore increasing their prices
as well. (Gagnon, Raskin, Remache, Sack, 2011) As a result, the holders of roughly all kinds of assets
should benefit from QE since their wealth increases. When the value of the households’ equities
increases so should also their consumption. Additionally, they are more willing to borrow against this
value. Also, banks are more willing to invest and lend since the value of their equities rises as well,
reducing the leverage. Similarly to the lower cost of borrowing channel, it should speed up economic
activity. However, in the case where households become richer in nominal terms by cashing their
equities but there is no further investments and output stays the same, as a consequence the wealth
effect may become only inflationary.
4. Money and market liquidity
When a central bank purchases assets, it provides the financial system with extra cash. This channel is
of vital importance especially for financial institutions being in distress. By accumulating reserves in
the Fed, they have a chance to get rid of “toxic assets” that became risky and significantly lost on value,
consequently deleveraging and improving its financial security. Additionally, a higher stock of money
would improve liquidity that usually lacks during the recessions. Therefore, it would encourage trading
and reduce the premia associated with illiquidity. (Carlin, Soskice, 2015) As a result of cash injections,
deleveraged banks would be more willing to invest and give loans, having accumulated enough
reserves to feel safe. Nevertheless, by following the monetarists’ intuition where MV=PY, the increased
stock of money (higher left-hand side) does not necessarily imply an increase in output, but might also
mean an increase in the price level. The most probable though is that this will affect both terms on
the right-hand side and the less willing are households to postpone their consumption for future
periods, the more visible will be the effect on inflation rather than on the real output. (Ellis, 2009)
5. Inflation expectations
When a central bank announces the plan of providing the system with almost infinite liquidity,
the inflation expectations are likely to increase. Historically, increases in money supply necessarily led
to the high price levels. However, according to the Lucas’ critique, historical relationships are prone to
break in new circumstances. (Bernanke, Reinhart, Sack, 2004) In any case, investors are likely to reckon
QE as inflationary. Hence, regardless of the actual effect of QE, high inflation expectations may push
the prices up but also eventually increase economic activity in the process. Since real interest rates are
equal to nominal ones subtracting the price level (r = i – π), a higher level of inflation could enable to
reach lower levels of real interest rates by pushing down lower bounds on real interest rates, hence
boosting the aggregate demand. The extent to which price level will actually increase depends much
on the shape of the Philips Curve, with higher inflation when firms respond by changing prices quickly.
6. Exchange rate
When investors expect lower yields in future periods, they will try to buy assets denominated in other
currencies. This should make the home currency to depreciate, affecting output by increased net
export. This channel is unlikely to affect the price level, however, the price level might affect
the exchange rate when the risk of uncontrolled inflation appears and investors scrap the currency,
which consequently depreciates.
The Three Equation Model:
The economy starts at the point A, with the real interest rate at minimum r(1). Provided the Fed did
not react, the next PC would be PC: π’(2), with expected inflation π(1) equal to the actual inflation at
the point A. However, anchored expectations (confidence channel - the market predictions are in
higher degree rational than adaptive so the PC shifts up each period by more than in the later case,
speeding up the adjustment process) and the inflationary shock (higher inflation expectations) push
the PC to PC: π(IN). Furthermore, the minimum level of the real interest rate does not go up but goes
down to r*(min)4 since the real cost of borrowing decreases (long-term interest rates), enabling the
move along the IS curve and a higher level of output as a result. Three channels affect the shift of the
IS curve to IS(1). Confidence among households and firms, wealth effect (both affect higher C and I)
and the exchange rate channel. The IS curve is dependent on the level of the real exchange rate, which
is likely to depreciate as the forex market expect the Fed to keep the interest rate low and continue its
QE programme. Hence, the new IS(1) curve refers to the new level of C, I and Q. Consequently, the Fed
is able to reach its desired point B and then move the economy along the MR curve to the point Z.
4
The real interest rate is shown as for firms and households rather than banks. Hence, r(min) is the lowest
attainable level of real interest rates for households and firms for the given inflation level, however not equal
to its negative value. Sign “=” is used as a simplification.
2. The Three Equation Model - possible transmission channels
What really happened. Analysis
1. Confidence
The confidence channel indeed brought some stabilisation to the US economy. It is easily visible by
looking at any graph presented during my analysis that market reactions come instantly after
an announcement, which means the belief in the Fed played an important role. Especially that with
announcements there also came promises of keeping the interest rate low or an amount of purchases
unchanged for a longer period of time, which made the policy predictable for market participants.
Specific effects of expectations on output and inflation will be considered together with other channels
throughout the analysis.
2. Lower cost of borrowing
There appeared some suggestions that QE might bring adverse effects such as hyperinflation, but not
reach its main objectives. The reason for this is because Treasuries of different maturities might work
as substitutes. Investors will switch to accumulate relevant short-term Treasuries and use an arbitrage
to equalise the yields. However, these suggesting the theory omitted an important aspect of risk
premia, which is an inherent feature of long-term assets, proving that these may not be substitutes for
the short-term ones. (Cochrane, 2014) But in order to evaluate whether the Fed actually succeeded in
lowering the yields, it is necessary to compare specific yield curves. In my analysis, I compared
the curves on the day before the announcement of a specific round of QE and the following day. I chose
the dates of announcing QE1, QE2, Operation Twist, QE3 and also a difference between June 2010,
when QE1 ended, and November 2011, when QE2 started.
3. QE1
4. QE2
5. June/November 2010
6. Operation Twist
7. QE3
Here, an important role played the expectations as yields had changed before the actual purchases
started. In the day of an announcement of the first round of QE, yields on 10-year Treasuries fell by
about 0.3 percentage points. When the Fed officially announced QE2, yields have slightly changed in
the opposite direction but this was because Ben Bernanke, the chairman of the Federal Reserve, had
already prepared the market so the decision had been expected and the market even overshot
the decision a little bit. However, if we compare the yield curve from June 2010, where the Fed ended
the first round of QE and the perspectives for the US economy seemed to be stable, with the curve
after the announcement of QE2 in November, the curves differ significantly and 10-year yields are at
record lows in the case of QE2. The decision of Operation Twist, which was specific considering its
structure of exchanging maturing short-term Treasuries on the long-term ones, not only lowered
the yields on the long-term Treasuries but it also made the interest rates on short-term 3-years
Treasuries slightly higher after the announcement, which is consistent with the structure of the plan.
The last round of QE had been expected and considered to be more as a maintenance of the ongoing
policy, hence no significant changes in yields occurred. Therefore, the policy was successful in
decreasing long-term interest rates and consequently the cost of borrowing.
Furthermore, by looking at the yields on corporate bonds we can see that they also decreased. It means
that the policy worked as expected and the market started looking for a new equilibrium by shifting
the demand to other instruments, which consequently lowered interest rates for a wide range of
assets.
8. Corporate bond yields
To answer the question whether the lower cost of borrowing pushed up the price level, I compare
changes in CPI for all goods for the US and the yields on 10-year notes.
9. Inflation and 10-year Treasury Yields
Interestingly, these trends seem to be positively correlated with changes in yields often occurring
before the respective changes in inflation. Moreover, this tendency seems to weaken or even
disappear together with the end of QE in 2014. Therefore, the suggestion that lower interest rates
could speed up economic activity to the extent which would hike inflation to dangerous levels has been
rather unfounded empirically. In the next paragraphs, I shall focus on wealth effect and money
creation, which are the sub-channels through which the cost of borrowing might have affected
inflation. Nevertheless, at first sight, lowered yields did not push inflation to high levels. Another
question is why they seem to be positively correlated. It may be on account of increased economic
activity in some periods, which would regain the investors’ trust in the economy, raising the yields and
also leading to higher inflation through increased activity. In this case, the policy of QE appears to be
successful, having stimulated activity by lowered borrowing cost without pushing inflation to
dangerous levels.
3. Wealth Effect
The wealth effect was considered by some to be both dangerous for the real economy and inflationary.
According to these suggestions, QE might just distort the capital allocation by malinvestments and
create bubbles as bullish trends of the asset prices are triggered also by the growth of money supply
that must be allocated somewhere. On the other hand, it can be inflationary since bond- and
shareholders’ wealth will increase and encourage higher spending. Also, the agents will borrow against
their increased wealth. When it also leads to higher economic activity, this effect is desired. However,
the problematic level of inflation may occur when investors cash their equities, increasing the nominal
spending in the economy stuck at the unchanged output level.
Firstly, I will look at NASDAQ, S&P 500 and Dow Jones Industrial Average to see the behaviour of
the market during the described period.
10. NASDAQ
11. S&P 500
12. Dow Jones Industrial Average
It can be easily seen that all indices behave similarly in the foregoing period, hence I will use Dow Jones
Industrial Average for further analysis. The bottom in the trend occurs at the beginning of 2009, from
which prices start to rise. We can also see that when the rally starts slowing down then the new round
of QE is announced and the stock is rocketing instantly.
13. Dow Jones Industrial Average (with QE announcements)
Although it is very likely that QE affected the stock prices, it is more difficult to assess to what extent
it was on account of growing expectations for further money injections, increased confidence in
the Fed or the effect of increased demand for assets. I shall skip this aspect as it is rather irrelevant in
evaluating the effect on inflation.
To see whether higher stock prices led to borrowing against the higher values of equity, I will compare
Dow Jones Industrial Average with the consumer credit in the economy.
20000
3800
3600
16000
3400
14000
3200
3000
12000
2800
10000
2600
8000
2400
6000
2200
Dow Jones Industrial Average
Billions of U.S. Dollars
Dow Jones Index
18000
Total Consumer Credit
14. Dow Jones Industrial Average and Total Consumer Credit
The total credit had been declining until the last months of 2010 when it rebounded and was going up
for the rest of the analysed period. It is feasible that wealth effect was an important factor that
increased the amount of credit. Especially that the hike appeared with a lag, which is consistent with
the fact that households needed to increase their wealth substantially to borrow against the higher
value of equities. However, we cannot reject the hypothesis that other aspects also played
an important role, such as better expectations coming as a result of the generally strengthening
economy in 2010, which made the households feel secure enough to start borrowing. But did
the wealth effect significantly increase inflation due to higher consumer credit and cashing the equities
from raising stocks? To check this, I will compare Dow Jones Industrial Average behaviour with CPI
Inflation changes.
19000
2.5
1.5
1.0
Index
15000
0.5
0.0
13000
-0.5
-1.0
11000
-1.5
-2.0
9000
-2.5
7000
-3.0
Dow Jones Industrial Average
15. Inflation and Dow Jones
CPI Inflation
Growth rate of inflation
2.0
17000
Some correlation is visible between these two. Nevertheless, there might be something affecting both,
such as improved economic conditions, which means that the correlation does not necessarily prove
wealth effect. On the contrary, the effect on inflation should occur with lags, with stockholders
increasing their spending when the market goes up and then prices would adjust afterwards. We
cannot observe any significant rises in the inflation rate following the bullish trends on the market.
Hence, I would conclude that the effect of increased asset prices on inflation was limited and
the concerns of too high inflation unnecessary. It is consistent with the theory that raising stock prices
would make better-off only a small part of the society who own the assets and even these, aware of
economic conditions being far from these before the crisis, would not be that willing to liquidate their
investments straight away but rather to postpone the consumption for further periods and build their
net worth prior to that.
Summing up, I would argue that wealth effect probably appeared as the effect which helped some of
the households to rebuild their net worth and triggered higher total credit in the economy.
Nevertheless, due to postponed consumption decisions and the fact that only a small part of
the society benefited, the price level was rather unaffected by overspending or too much borrowing.
The price level might have slightly increased with significant lags due to the improved situation of
households in the long run, but this would be desired as coming together with increased economic
activity and higher output.
4. Money and market liquidity
When the Fed started purchasing assets in return for newly created money, some argued that these
money injections will substantially expand the stock of money and not necessarily close the output
gap. Furthermore, the economy will “get addicted” to these injections, which will make it impossible
to exit this policy smoothly. Consequently, either the value of the US Dollar will be falling continuously
or the Fed will stop QE, which will bring the even bigger recession to the QE-addicted economy.
Basing on the famous equation MV=PY, one may conclude that since the output (Y) growth is limited,
with the growing money supply (M) the prices (P) will necessarily grow as well if money velocity (V) is
assumed to be constant. Nonetheless, a few counterarguments were proposed. First of all, QE does
not necessarily have to be inflationary by nature, not directly at least. If the assets are purchased from
the non-banking institutions, then these assets are removed from the system and must be replaced
with something else, hence the balance sheet of the banking system increases. Deposits increase on
the liabilities side and reserves on the assets side. However, when the banks are the ones owning
the assets, when the Fed buys the assets it is an action of a liquidity swap rather than money creation.
The Fed removes assets from the economy and replaces them with reserves. However, since
the reserves are not lent by banks instantly, the stock of broad money does not expand and the whole
process is just a change in a composition of banks’ balance sheets with more liquidity.
(Ennis, Wolman, 2011) Therefore, QE can be inflationary directly only if most of the assets were held
by non-banking institutions, which was not the case during the crisis. Otherwise, when banks are
the ones owning the assets, they are likely to deleverage by accumulating the reserves and not
increase their balance sheets. In these circumstances, QE is not inflationary. It may become eventually
if it achieves its intended purpose of stimulating more economic activity by fuelling bank lending and
money creation. (Brightman, 2015) When QE was introduced, there were also introduced stricter
capital requirements and refreshed risk-management approach. In this situation, banks decided to
cure their balance sheets, holding the high level of reserves instead of going into risky credit creation.
They decided to accumulate rather than lend to such the extent that not only did it prevent
the economy from hyperinflation but it also forced the Fed to increase QE as banks did not lend as
much as the Fed wished and the economy was still experiencing deflationary pressure. The incentive
that ceased the excessive search for returns in risky investments was the decision of starting paying
interests on reserves held at the Fed. Since the end of 2008, the 3-month Treasury bill rate has been
below 25 basis points the majority of the time. For a bank choosing how to allocate its liquid assets,
there was a good reason to prefer reserves yielding 25bps to Treasury bills. Summing up, in a situation
where nominal interest rates are far from zero and where the Fed does not pay interest on reserves,
it is generally agreed that a policy of massively expanding the quantity of bank reserves would
eventually affect the price level. However, both the Fed’s decision to pay the interest and the fact that
the interest rate in the economy was generally low substantially reduced the expansion of the broad
money. (Ennis, Wolman, 2011)
16. Monetary base and banks' reserves held at the Fed
As we may see, it is clearly visible when each round of QE occurred and when the Fed decided to start
tapering. As expected, monetary base increased substantially throughout the period, more than
quadrupling from 2008. However, the path of reserves held by the commercial banks almost exactly
followed the path of the monetary base. It means that banks did not decide to increase credit creation
significantly.
17. M3
M3 aggregate, commonly referred to as broad money, has not expanded dangerously, proving
the point. I chose here the period from 2005 to show that the trend was roughly unchanged with only
two higher increases when Q1 and Q3 occurred. To show it better, I present the growth rate of M3 for
the US.
18. M3 - growth rate
Even though two bumps are visible, these changes are considerably smaller in magnitude that these
of the monetary base. Therefore, they could not have led to hyperinflation but only stimulated
the economy instead, which was the Fed’s aim.
Another counterargument against the fears of hyperinflation is money velocity, which is on the lefthand side of the equation of exchange. Velocity, often assumed to be constant, in this case fell
substantially.
19. Velocity of circulation
4500.000
1.800
4000.000
1.700
1.600
3000.000
2500.000
1.500
2000.000
1.400
Velocity Ratio
Billions of U.S. dollars
3500.000
1500.000
1.300
1000.000
1.200
500.000
0.000
1.100
Monetary Base
MZM Money Stock Velocity
20. Velocity and monetary base
Velocity increased during the first round of QE, however falling constantly throughout further periods.
It can be easily explained by the fact that trading and spending increased when the previously lacked
liquidity finally appeared together with QE1, but in general households and firms, as previously
mentioned, decided to postpone consumption and investments with their expectations still far from
being neutral. This effect had been possible to predict on account of the characteristics of the ZLB on
nominal interest rates, which incline to hoard the cash. It means that when extra cash directed into
the economy satiates the public’s demand for money and provides no transaction services to
households and firms, money becomes just a financial asset that pays a zero nominal interest rate,
is riskless in nominal terms and has indefinite maturity. (Bernanke, Reinhart, Sack, 2004)
Summing up, even though the Fed increased the monetary base, it did not increase the stock of broad
money but only enabled the banks to do so. However, there were also taken some measures that
discouraged them from doing that too excessively. The Fed started paying interest on reserves and
strict financial regulations were introduced. Furthermore, the possibility of hyperinflation was reduced
by the behaviour of market participants who preferred to avoid the risk and increase their net worth,
postponing consumption and investment decisions. It lowered the velocity ratio and also slowed down
the expansion of broad money. Therefore, QE again appears to be successful, especially in terms of
providing liquidity (mainly QE1) and enabling financial institutions to amass reserves and improve their
balance sheets without triggering excessive inflation.
5. Inflation expectations
21. Inflation expectations
The graph above presents average 5-year inflation expectations at the date. We may notice that
inflation expectations reacted strongly and instantly to the announcements of each round of QE.
The strongest hike occurred in December 2008 when the Fed introduced the first round of the policy.
Worth emphasising is the fact that expectations were higher than actual inflation throughout the given
period. Market participants believed that the policy might lead to a quick expansion of the money stock
and as a result to high inflation. However, as it turned out, the programme whose aim was to provide
more liquidity was not inflationary to the extent that it had been expected. Banks reacted much slower
with credit creation, accumulating reserves to record highs and households were more spendingaverse. Furthermore, stronger regulatory pressure on banks and other financial institutions
contributed to this less rapid than expected inflation increase by forcing the banks to deleverage.
Nevertheless, inflation expectations probably played a role in affecting the real inflation. As we look at
the graph below, we can notice that in many cases the actual inflation trend follows the expectations
trend, indicating that higher expectations might have boosted consumers’ confidence and led to
increased spending, consequently affecting the actual price level. However, once again the threat of
hyperinflation was unnecessary as the expectations overshot the actual inflation, not the opposite.
22. Actual and expected inflation
6. Exchange rate
When QE was announced, at first the value of the US Dollar compared to the basket of currencies
increased, however consistently falling after the initial shock. It started regaining its value with
the improvement of financial conditions in 2010 and fell again with the announcement of QE2 and
QE3.
23. U.S. Dollar Index
Nevertheless, decreases in the value of the US Dollar did not help the exporters. Conversely, there is
a positive trend between net export and the U.S. Dollar Index, indicating that falling value of Dollar
might have been decreasing net export. We can see that Net Export trend follows the trend of
the Dollar Index with small lags.
-300
125
120
Billions of U.S. Dollars
-400
-450
115
-500
-550
110
-600
105
-650
-700
100
-750
-800
95
Net Export
24. U.S. Dollar Index/Net Export
U.S. Dollar Index
U.S. Dollar Index; 1997=100
-350
Consequently, it is justifiable to conclude that this channel was not particularly relevant for boosting
the aggregate demand and is often skipped in similar analyses. It is also not especially relevant for
inflation. Even though the US Dollar Index and the inflation seem to be negatively correlated, it is more
probable that changes in inflation affected the value of the currency more than the other way round.
115
2.5
2.0
110
1.0
0.5
0.0
105
-0.5
-1.0
-1.5
100
-2.0
Growth Rate of Inflation
U.S. Dollar Index; 1997=100
1.5
-2.5
-3.0
95
2008-01-01
-3.5
2009-01-01
2010-01-01
2011-01-01
U.S. Dollar Index
2012-01-01
2013-01-01
2014-01-01
CPI Inflation
25. U.S. Dollar Index/CPI Inflation
Conclusion. Is there a danger of hyperinflation in the near future?
QE in the US is believed to have affected both the output and the inflation and it is hard to undermine
these claims. Nevertheless, from the time perspective, we must admit that the fears of hyperinflation
and destroyed value of money were strongly exaggerated. The Fed managed to decrease long-term
yields and lower the cost of borrowing, boosting the aggregate demand, at the same time saving
the falling banks by providing liquidity and enabling them to deleverage by accumulating reserves.
It also managed to quit the policy while keeping the economic growth roughly unchanged. Although it
is unarguable that the Fed gave a tool for the banks to trigger high inflation by broadening the money
stock, I would say that the Fed had the reasons to believe that on account of the regulations and
the shortage of profitable opportunities after the recession, the behaviour of market participants
would be rational and restrained enough not to bring the adverse effects on inflation.
But in this case another problem arises. Even though too high inflation has not appeared yet, many are
concerned that if and when loan demand accelerates and banks cure their balance sheets, the Fed will
need to drain the excess reserves created by QE from the system in order to avoid rapid money
creation and inflation. (Brightman, 2015) It stands to reason to admit that banks indeed have enough
excess reserves to immediately start a rapid credit creation, which could be harmful to the economy.
However, it is unreasonable to say that the banks could find such a number of potentially reliable loan
takers and investment opportunities. Especially in the environment of the interest-on-reserves paying
central bank. In this case, it is more profitable for banks to hold excess reserves than to decide to
provide loans to the agents of a high degree of risk. Thus, to start a heavy credit creation it would
require an unbelievably high level of demand for credit, all from reliable agents. Empirically, as we
come back to the graph 17 showing the velocity ratio, we may see that after QE, the ratio is still on
downward or stabilising trend, meaning that demand for money is not growing significantly. Even
though the level of reserves held at the Fed has actually slightly decreased since 2014 when the Fed
ended tapering, meaning that banks moved some of the resources to other investment opportunities
and credit creation, I would still advocate that this is a sign of the healed economy rather than banks
excessively developing credit action once they feel secure. Especially that despite the decreasing trend,
the level of reserves has been volatile, going up and down recently rather than plunging suddenly.
Consequently, they are still at historical highs with banks being very unlikely to use them all instantly
in the near future.
26. Reserves held at the Fed
Nevertheless, even provided that banks found excessively many opportunities from which
the expected return is higher than a risk-free account at the Fed, it is enough for the Federal Reserve
to raise the interest rate to push the level of the required expected return higher, hence reducing
the number of profitable opportunities. With the rates on the record lows, the Fed has a big field to
do so. This process should have an immediate effect as excess reserves would be paying higher returns
without any lags. Consequently, it would be more sensible for banks to keep the high level of reserves,
enabling the Fed to easily control the level of credit creation in the economy and the expansion of
the broad money stock.
27. Commercial and Industrial Loans
It is visible in the graph that the tapering from 2014 did not slow down the pace of growth of loans.
Nevertheless, the trend has changed to become slightly flatter in 2016, when the Fed raised
the interest rates and promised a few further hikes in 2017. It only proves the claim that
the conventional channel of adjusting the interest rate has become powerful again.
References:
1. Colin Ellis: “Quantitative Easing: Will It Generate Demand or Inflation?” (2009)
2. Joseph Gagnon, Matthew Raskin, Julie Remache, Brian Sack: "The Financial Market Effects of the
Federal Reserve's Large-Scale Asset Purchases" (2011)
3. Wendy Carlin, David Soskice: "Macroeconomics: Institutions, Instability, and the Financial System"
(2015)
4. Ben Bernanke, Vincent Reinhart, Brian Sack: "Monetary Policy Alternatives at the Zero Bound: An
Empirical Assessment" (2004)
5. John Cochrane: "Monetary Policy with Interest on Reserves" (2014)
6. Huberto Ennis, Alexander Wolman: "Large Excess Reserves in the U.S.: A View from the CrossSection of Banks" (2011)
7. Chris Brightman: "What's Up? Quantitative Easing and Inflation" (2015)
Graphs:
1-2: Produced on my own
3-7: US Department of the Treasury: Resource Center
8-13, 16-19, 21-23, 26-27: Fred Economic Data
14, 15, 20, 24, 25: Produced on my own basing on the Fred Economic Data