Josh Dowlut's  Instablog

The absolute worst case inflation scenario of continued quantitative easing (QE) would involve the entire world losing confidence in the dollar, simultaneously dumping US currency and US Treasury securities, the lender of last resort becoming the lender of only resort, and monetizing the entire deficit.  Given a set of known figures, this translates into an initial inflation shock of roughly 52%, followed by an annual inflation rate of 13-15%.  Painful yes.  Government toppling as many fear mongers have suggested, no.

It is commonly accepted monetary theory that only the M2 broad money supply relative to the amount of stuff to buy with it affects inflation.  M2 is currently $8.65 trillion.  Foreign holdings of US Treasury securities total $4.21 trillion.  University of Wisconsin economist Edgar Feige estimated in 2009 that 30% of the $965 billion of US currency in circulation is held abroad for an estimated total of $298 billion.  Finally, the CBO estimates the 2010 federal deficit to be $1.3 trillion.  With this set of givens as our inputs, calculating the effect on M2 and thus the inflation rate under a total crisis of confidence scenario is relatively easy.  If currency held abroad is sent home to circulate domestically, that will increase the price of domestic consumption.  If foreign holders of US Treasury securities sell their IOUs, someone will have to buy them to keep the price from plummeting and the yields from skyrocketing.  That someone is the Fed.

First, M2 would very quickly grow from $8.65T to $13.16T, an increase of 52%.  This would likely happen faster than the real supply of goods could increase by any appreciable amount thus virtually the entire growth in M2 would translate into inflation.  After the initial shock, with confidence lost and no traditional lenders to borrow from, the entire federal deficit would have to be plugged through debt monetization.  Given that entitlements, and most government pay, ergo most of the budget and deficit is pegged to inflation, that deficit would stay in proportion to the new M2 supply and new nominal GDP, roughly 15%.  Given 2% growth in the amount of real stuff to buy, that would translate to roughly 13% inflation, or 15% under total real stagnation.

The US has lived through double digit inflation before.  1974 saw 10-12% inflation and 1979-1981 saw 10-14% inflation.  Continued quantitative easing is a painful scenario, but it's a far cry from Weimar or Zimbabwe.  Gold would soar.  Any industry dependent on the discretionary spending of the middle class would get crushed as consumers cut back on nicities to afford necessities.  Inferior goods industries such as Walmart, Dollar Tree, and McDonalds would do well.

Additional, inflationary factors that would mostly distort relative prices in addition to general prices:

• US currency and securities dumping could lead to specific foreign currency appreciation (depending what the dollar denominated reserves are replaced with) and therefore an increase to US import costs beyond the inflation of M2 expansion.  Total imports are only 17% of GDP however.
• Petrodollars would cease to exist and the price of oil for Americans would increase beyond the inflation of M2 expansion and likely beyond even the increase in the relative price level of total imports.  Oil imports are 2% of GDP.

To address a working assumption some may have picked up on by now:  The Fed will continue to incentivize banks to sit on their excess reserves by paying them not to lend.  The entire point of QE is to maintain and preserve the system, not bring it down.  The sure-firest way to bring the system down would be to allow the broad money supply to increase by a factor of 10 or more.  This is about keeping banks solvent, and keeping rates low.  Bernanke is more likely to allow deflation than he is to allow a 10 fold or more increase in the broad money supply and the 1000%+ inflation that would accompany it.  Given the mission at hand, given the players involved, and given reality as it currently stands, this is the worst possible case scenario.
 

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