After QE2, What Then?

by: Calafia Beach Pundit

I keep coming back to the issue of money, QE2, and inflation because it is so important. Here's a summary/clarification of my most recent post on the subject, as well as other related comments I've made along the way:

The Fed has expanded bank reserves and the monetary base massively, creating the potential for hyperinflation. (In our fractional reserve banking system, each new dollar of reserves potentially can support about $10 new dollars of bank deposits.) But so far, none of this "money printing" has shown up in traditional measures of the money supply (e.g., currency, M1, and M2), which display no unusual level of growth in recent years. (In fact, they are growing at a much slower rate today than they did in the inflationary 1970s.) Indeed, virtually all of the reserves created by the Fed to pay for its security purchases are sitting idle, in the form of excess reserves, at the Fed.

Without a huge increase in the actual amount of money in the economy, we are unlikely to see a huge increase in inflation. Alternatively, a significant decline in the demand for money could support a rise in the price level, but there is no evidence to date that this is occurring (except for the fact that the dollar is trading at record lows).

Meanwhile, market-based and leading indicators of inflation strongly suggest that the Fed has supplied more money to the world than the world wants (e.g., the extreme weakness of the dollar, soaring gold and commodity prices, the very steep yield curve, and rising breakeven inflation rates on TIPS). It is an over-supply of money that debases a currency's value, leading to a general rise in the price level, just as an oversupply of houses relative to housing demand has led to a significant decline in housing values in recent years.

So while there is no obvious evidence that the Fed has committed a major inflationary faux pas, there is evidence to suggest that inflation is headed higher. And although banks have yet to utilize their huge stock of excess reserves to greatly expand the money supply, there is no reason to think that won't happen in the future, nor any compelling reason to think the Fed will be able to respond (by cancelling QE2 and/or withdrawing reserves) in time to prevent banks from doing so (e.g., how aggressive can the Fed get if the economy is still struggling to recover?). Conclusion: Investors need to be prepared for higher inflation, but there is no reason yet to panic.

The chart below shows a 16-year history of M2, in order to underscore the point that to date, there has been no unusual expansion in the amount of money sloshing around the economy. M2 has grown about 6% per year on average since 1995. Over that same period, the GDP deflator (the broadest measure of inflation) has risen about 2% on average, and real GDP has increased about 4.6% per year on average (all compounded, by the way). In other words, the amount of money in the economy actually has grown by a little less than the growth in the nominal size of the economy (i.e., 6% vs. 6.7% per year).

[Click to enlarge]

There are still some important questions to be answered, however. How can there not have been any new money printed, if the Fed has purchased almost $1.5 trillion of Treasuries and MBS since late 2008? What happened to the $1.5 trillion that the sellers of those securities received? Can the quantitative easing process continue indefinitely without inflationary consequences? What will happen if/when quantitative easing stops?

The short answer to the first question (why no new money?) is that at the end of the day, two things happened: 1) banks were willing to hold on to the new reserves, and not use them to increase their lending, and 2) the world in aggregate did not want to increase its dollar borrowings. Another way to put this is that the extra reserves satisfied the world's demand for additional safe and liquid assets. At the same time, the Fed effectively swapped reserves (a kind of T-bill equivalent) for T-Notes and MBS, thus shortening the maturity of federal debt and reducing the private sector's exposure to rising interest rates.

Can this continue indefinitely without inflationary consequences? I doubt it. But there is a certain vicious-cycle aspect to all this that is troubling. The more the government borrows (with the federal deficit on track to hit 10% of GDP, a very large number by any standard), the more the government spends; the more the government spends, the less efficient the economy becomes; the less efficient the economy, the slower it grows; the slower the economy, the fewer attractive investment opportunities there are, and thus the more attractive Treasury debt becomes, even if interest rates are very low relative to inflation. This same dynamic may help explain why Japan has had deficits of more than 10% of GDP for many years, yet the yields on government bonds remain extraordinarily low and economic growth has been disappointingly slow.

Is the end of quantitative easing going to be painful? Not necessarily. The end of QE2 means only that the Fed will stop swapping reserves for longer-maturity securities. There will still be a mountain of excess reserves in the system. Even if the Fed were to start "tightening" immediately after the end of QE2, that "tightening" would hardly be considered problematic, since it could take years to reverse all the injections of reserves.

And in lieu of actually reversing its reserve injections, the Fed could simply decide to pay a higher rate of interest on existing reserves. This would have the effect of raising short-term interest rates without reducing the supply of reserves. The steepness of the yield curve is proof that the market is already braced for short-term interest rates to rise by hundreds of basis points. The issue is not whether the Fed will begin tightening or by how much it will tighten; the issue is when and how fast it will start raising rates.

It is entirely conceivable that a rise in interest rates that results from a Fed tightening will have the effect of increasing the world's demand for longer-maturity securities, thus obviating the need for the Fed to continue swapping reserves for longer-maturity securities.

I hope it's clear that I'm trying to take an objective and dispassionate view of things. There is reason to be concerned, but not yet any reason to panic.