Why QE Didn't Generate Inflation

 |  Includes: IEF, TIP
by: Robert Wagner

We are now almost five years past Jim Cramer's rant about the "Fed knows nothing" and QE-finity and yet we don't have hyperinflation, the U.S. dollar never collapsed, no insured bank deposits were lost, the banking system didn't collapse and the economy is slowly recovering without much or any help from the fiscal side of the ledger. How can all this be possible? All the critics were so sure that America was headed for ruin, and the Fed was the No. 1 cause.

The reason none of these events occurred can be boiled down to one simple theory, we don't have inflation and a collapsing economy because the markets trust the Fed. It is that simple. If the markets didn't trust the Fed, all the awful things outlined above would have occurred, yet they didn't. This is even more remarkable given the dysfunction we have in Washington. One could easily make the case that the economy is recovering in spite of the failure in Washington, and that the only macro policies that are supporting the economy are monetary. Obamacare, Dodd-Frank, new carbon-based EPA regulations and a whole host of other regulations and new taxes have greatly hindered the recovery, yet we continue to stumble forward.

The reason the markets are at or near all-time highs and the economy is slowly recovering is because the markets simply believed the Fed more than they believed the Fed critics. What the critics failed to understand or refused to recognize is that the Fed can't just "print money out of thin air" in some random, irrational and irresponsible way. The Fed is controlled by a "duel mandate" that defines the parameters in which the Fed can "print money out of thin air." The Fed has to balance unemployment and price stability, so if inflation ever does develop above the targeted level, the Fed has the obligation slow it down. Ironically the very entity the critics claim will cause inflation is in reality the very entity that ensures that inflation won't develop.

In this video, Bill Griffith asks the most important question the critics fail to ask or consider, "what would the economy look like if there were no QE?" Facts are, without QE it is highly likely the economy would be in shambles, with many similarities to the Great Depression. The Fed responded to the 2008 crisis in almost the exact opposite manner it did in the 1930s. In the 1930s the Fed allowed the banking system to collapse, and when the banking system collapsed, the economy collapsed with it. This time, the Fed worked overtime flooding the banking system with liquidity to ensure the banking system wouldn't be the anchor to drag the economy down. There are plenty of complicated mechanics to explain monetary policy, and I tried to outline them in past articles, but in reality what really matters isn't the mechanics, it is the market's perception. If the markets don't believe the efforts of the Fed will succeed, they will react accordingly, and as of right now, almost five years past the crisis, the markets are acting as if they trust the Fed.

Can the Fed solve all our problems? Absolutely not. Many, if not most of our problems are not monetary problems. The Fed can stabilize the banking system, but the Fed can't do anything about issues like run away spending by Congress, solving the energy, education and healthcare crisis, reforming the tax and regulatory codes and a whole host of other challenges facing this Nation. Those challenges must be solved by the free market and competent leadership in Washington, not the Fed.

In conclusion, the reason we didn't fall into economic Armageddon and why we don't have hyperinflation is simply because the markets have faith if the actions of the Federal Reserve. There is no way the markets would accept 2.00% on a 10-year Treasury bond if they believed there was a real threat of inflation. The U.S. debt is almost $17 trillion, the $85 billion in Treasuries and MBS that the Fed is currently buying each month is hardly enough to substantially suppress such a huge market. If the markets truly feared inflation, there is little the Fed could do to keep rates low. The only reason rates are so low is because the markets trust the Fed, and as long as that confidence remains, investors can remain confident that interest rates will remain at a level supportive of economic and employment growth with relatively low inflation. If the markets were to lose confidence in the Fed, the "bond vigilantes" would saddle up and ride into town to restore peace and order. Even if the Fed wanted to create inflation above what was tolerable to the markets it likely wouldn't be able to because the bond rates would increase to such a level as to choke off economic growth resulting in lower inflation. Inflation is too many dollars chasing too few goods, and higher interest rates simply reduce the number of dollars chasing goods. The critics of the Fed seem to ignore that the Fed isn't the only entity that can increase interest rates, the market can increase interest rates on its own, and it will if it ever loses confidence in the Fed, but so far that hasn't happened.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: This article is not an investment recommendation. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.