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Five years ago when Chairman Ben Bernanke started using quantitative easing (QE) to save the economy, the Federal Reserve was made into a one-way street with no return. With the unprecedented amount of new money being injected into the economy, there is no way to reverse course. All the talk now of tapering is merely propaganda to placate global markets. Going forward, the excess liquidity created by QE will translate into inflation, which is what the Fed (not openly) is trying to pursue. Persistently high inflation not only will ease the real debt burden of private sector, but it also will reduce the real value of the liquidity that the Fed created and the debt that the Treasury issued - in much the same way as an actual unwinding of stimulus.

Since the introduction of QE, everything that could be going right for the recovery has been going right. Unemployment, for example, has come down and the stock market has been in a surprisingly strong rally that many experienced investors find it puzzling. Inflation is nowhere in sight. The U.S. dollar is holding up pretty well. It turns out that the Fed has made a bit of history by proving that "printing money" works.

But is that really so?

QE, in simple words, is the process whereby a central bank uses newly created money to buy financial assets (e.g. government debts and mortgage debts) from the private sector. It is an unconventional monetary tool to stimulate the economy when short-term interest rates are already at or near zero. By creating an artificial demand for these assets, the central bank could push down the interest rates of these long-term debt instruments. Also, by buying up all these assets, the transaction could swap private sector's holding of treasury and mortgage securities for deposits. The result is an increase in reserves of banks (which are banks' deposits with central bank) and a rise in bank deposits of non-bank corporations and individuals.

And therein lies the rub. Because deposits earn almost no interest, holders of newly created money have every incentive to get rid of it in search of higher return alternatives, such as equities, or in form of consumption. Banks, theoretically, would also extend more loans. All in all, the newly created money is pretty much like a hot potato passing from one party to another, and in each turn (when money changes from buyer's pocket to seller's pocket) either the financial market or the economy would get a boost. So while QE does not add net new financial assets to the private sector, it will bring about an increase in both asset price and general price - in other words, it is inflationary.

Chart 1

(click to enlarge)

Chart 1 above shows how the U.S. economy fared after the 2008 financial crisis. Here, I use nominal value of output so that the impact of "money printing" could be analyzed more clearly on a one-to-one dollar basis. As we can see, consumption has been the linchpin of GDP recovery. This is a bit of a surprise, for consumers seem to have kept up their end even as millions of them get thrown out of jobs. The oddity, however, is that government transfers have lent epic support to consumer spending. Let's look at Chart 2. Take 3Q13 as an example, the nominal value of consumption (annualized because it is a quarterly data) was almost US$1,800 billion above 2007 level, far outpacing growth in wages, which was up only about US$1,000 billion. Yet, in that period, income from government social benefits (yellow bar) jumped nearly US$600 billion, providing extra spending cash for consumers. In essence, therefore, the government is handing out money to consumers so that they can spend the way they feel. This, on top of the roughly US$350 billion additional government spending (blue line in Chart 1), has kept the economy ticking along.

Chart 2

(click to enlarge)

There is a serious point here. The government does not have enough income to cover all these expenditures and has to borrow every year to make up the shortfall (see Chart 3A). Because the Fed is a big buyer of Treasury debts, much of this borrowed money is in fact the money printed by QE (see Chart 3B). How then can the Fed slow the money printing presses? There is no way. Fiscal spending and QE are indeed an unseparated package to stimulate the post-crisis economy. Without QE to monetize the fiscal deficit, interest rates will shoot up and choke off the fragile recovery.

Chart 3A

(click to enlarge)

Chart 3B

(click to enlarge)

For certain, the U.S. economy cannot afford a spike in interest rates. This is not just because that will increase government's burden of servicing debt. As we can see from Chart 4, investment has been a drag on the economy after the collapse of the housing market, and it is only until recently that the nominal value of investment has returned to pre-crisis level. Weak residential investment and non-residential structure investment are mostly to blame, because property market recovery remains anemic. If the recovery is to take hold, higher interest rates are the last thing the economy needs.

Chart 4

(click to enlarge)

The fact that inflation remains subdued is further evidence that there are slacks in the economy. That said, there is little reason for the Fed to rush ahead with rate hikes. It may taper asset purchase down the road, but would not end the QE program unless there are clear signs of solid recovery and until the massive fiscal stimulus is withdrawn. Before this happens, monetary policy will continue to be highly accommodative even as the economy is running at full tilt. The Fed will just turn a blind eye to inflation.

Right now, banks are flush with reserves but hesitant to lend, companies are cash-rich but reluctant to invest, and consumers are still cautious to spend. But when sentiment improves, the huge amount of QE liquidity will flow out to buy up goods - and at some point inflation will begin to kick in.

It is true that the Fed has the tools - such as raising the interest rate on excess bank reserves or even imposing a reserve requirement on all deposit categories - to limit credit expansion if inflation turns up. But as mentioned earlier, the central bank's QE action has resulted in an enormous amount of deposits in the hands of the public as well. This money does not necessarily need to go through banking systems' lending and borrowing process to create inflation. To think of this situation, you can imagine if depositors are all scrambling out to purchase goods, even though the Fed uses its tools to hold down velocity of circulation, there can still be inflationary pressure arising.

Furthermore, I have serious doubts that the Fed would slam on its brakes. As I see it, so long as inflation is not racing out of control, the central bank would opt to stay on the sidelines and let inflation eat away the country's colossal public debts.

Truth to tell, after years of deficit spending and quantitative easing, the scale of the stimulus has made it impossible for the Fed to sell off its bonds or the government to pay back its debts. Inflation is the only way out. The most daunting task facing Janet Yellen, the next Fed chief, is how to engineer a long period of controlled inflation, quite the reverse of what a central banker is supposed to do. In this environment, the U.S. stock market will head higher on the back of strong earnings due to higher sales prices.

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.

Source: Inflation Is The Last Piece Of The QE Puzzle