Monday, 27 May 2013

Inflation, deflation and QE

Inflation is dead.

Well, in the US, anyway:

What is curious is that the US is doing QE. Lots of it. Which is supposed to raise inflation, isn't it?

Then there is Japan. Japan recently embarked on an extensive QE programme designed to raise inflation to 2%. Here's the path of Japanese inflation:

Historical Data Chart

It's very easy to see where QE started. It's when inflation fell off a cliff. Well, ok, it might have done that anyway, I suppose. Correlation doesn't equal causation, and all that. But it is curious.

Japan has, of course, done QE before. A look at the inflation path for the period 2001-2006, when Japan was doing QE, doesn't suggest a close relationship between QE and inflation. 

Historical Data Chart

The initial impact seems to have been deflation, though again we could do with a counterfactual. But for the rest of the period QE seems to have had little impact on inflation. In fact a researcher at the IMF concluded that QE's effect on inflation was small.

The UK does appear to buck the trend, since it experienced above-target inflation ever since commencing its QE programme, still the largest in the world relative to GDP although it is currently suspended. Though it is interesting that throughout 2012, when the Bank of England was doing QE, CPI was falling - it picked up in November 2012 when QE stopped:

Historical Data Chart

But this isn't quite what it appears. The UK's CPI was pushed up by tax rises, student tuition fee increases (what on EARTH are they doing in measures of CPI anyway?) and above-inflation rises in near-monopoly privatised utilities which are subject to government price controls. Yes, really. Government not only allowed those above-inflation rises, it encouraged them in the name of investment - though why it thinks utilities should invest for the future now when it isn't doing so itself is a mystery. And the other significant component of CPI in the UK is imports of essential items, notably oil. I suppose you could blame this on QE to some extent, because of its tendency to push up world commodity prices - but externally-driven cost-push inflation wasn't exactly what was wanted, was it? Anyway, the poisonous combination of external factors and government mismanagement pushed inflation up while real incomes have been falling. How to squash domestic demand in one easy lesson.....the effect on retail sales, for example, is horrible.

When you strip those effects away from the UK's CPI, it appears that inflation is dead there too. The Bank of England has been doing exactly this: it has "looked through" CPI to see the underlying deflationary trend. Not that it is planning any more QE at the moment. It is waiting to see how the Funding For Lending scheme works: this takes a different approach to reflating the economy involving new short-term government debt issuance rather than money - on the face of it a promising approach though to my mind it still relies far too much on damaged banks for its effects. But it seems the Bank is also thinking about negative rates.

Given the considerable evidence that QE does not raise core inflation in the countries doing it, it is a mystery to me why people are still talking as if it does. Bullard, for example, saying he thought the Fed's QE programme should continue until inflation hit 2%. And the Bank of Japan supposedly targeting 2% inflation, though no-one really believes it (or do they? it seems "inflation expectations" in Japan are up....). And all the talk of inflation being a serious risk from QE exit, as if QE exit is going to happen any time soon. Yes, Bernanke is talking about "tapering off". That isn't exiting QE. It's stopping it. Exiting QE (by which I mean returning the purchased assets to the private sector) is about as easy as ending capital controls and, like capital controls, will take years and years if it happens at all. And while inflation remains low there is no reason whatsoever to exit QE. If, in some future universe, inflation were to spike due to bank profligacy in the presence of enormous bank reserves, it is reasonable to suppose that inflation-targeting central banks would promptly drain those reserves by selling the purchased securities. Yes, I know the bond vigilantes dispute the existence of a market for such a large quantity of securities, but the private sector sold them in the first place, so why wouldn't they buy them back? Really the idea of a buyers' strike on central bank sales of securities makes no sense at all. The problem would be managing the pace of sales, taking into account impacts on inflation and on government finances.

So QE is NOT INFLATIONARY. Not now, and not ever. Let's put a stake through the heart of the idea that central bank "recklessness", as some people call it, will cause massive inflation.

The chart evidence above seems to show that if anything, QE has deflationary rather than inflationary effects. (yes, I know, correlation isn't causation, counterfactual....). But it has been difficult to come up with a convincing explanation for this. This post is my first attempt. I do not pretend to have a complete answer, and for that reason I am creating an open space on the Coppola Comment blogsite where the debate can continue and people can pool information and ideas on this subject.  We must find the answer....because if I am right, then QE is one of the biggest policy mistakes in history.

In my view the apparently deflationary impact of QE is due to what Stephen King calls its "unwanted redistributive effects", so is an indirect rather than direct effect. As the Bank of England noted in its review of QE's distributive effects, QE benefits the asset-rich at the expense of the income-dependent. To understand this, it is necessary to look at the context in which central banks do QE. The typical picture is of a stagnant economy with high unemployment, a high household savings rate (actual savings or debt deleveraging), risk-averse companies that are reluctant to invest, and - crucially - a damaged financial sector.

QE supports asset prices. Clearly, this most benefits those who own assets - who tend to be the rich and the old. In the aftermath of the 2008 financial crisis QE prevented catastrophic deleveraging and economic collapse: it was an emergency response to a desperate situation.  But since then, the debate has moved on, the benefits of supporting asset prices now are by no means clear and there appear to be all manner of unintended consequences.

QE is supposed to nudge investors towards riskier investments by raising the price of safer ones. And it is succeeding in this: bond prices are at an all-time high and the stock market is reaching for the moon. This is supposed to reduce the cost of investment for those firms that can raise funds on the capital markets - i.e. larger companies. It doesn't help small businesses who don't have access to capital markets. That assistance was supposed to come through bank lending - but banks don't want to lend to risky businesses at the moment. But it doesn't seem that the reduction in borrowing costs for larger companies has encouraged them to invest for the future either. On the contrary, it seems they have been buying other assets....notably their own shares. There has been a swathe of share buy-backs in the corporate world, partly paid for with their extensive cash hoards and partly funded with cheap borrowing from the capital markets. Debt for equity swaps are all the rage. This does nothing whatsoever to improve growth, employment or income.

So we have a broken transmission mechanism. We often hear about a broken money transmission mechanism due to damaged banks, but we don't often hear about a broken EMPLOYMENT transmission mechanism due to damaged corporates. Far from QE support of asset prices enabling companies to invest for the future and employ lots of people, it encourages them to indulge in financial jiggery-pokery to shore up their balance sheets and maintain directors' incomes, while using high unemployment and government wage support systems as an excuse to force down wages. The sheer amount of spin from corporates about lack of investment opportunities is exceeded only by their constant moaning about quality of labour. You would think that the developed countries offer no opportunities for future profits, despite their skilled and flexible workforces and supportive infrastructure. And governments pander to this: they fund skills development programmes to compensate for the training that companies aren't doing, they cut benefits to force people to take on more work - any work, however unsuited to their skill set and however badly paid - and they cut corporate taxes as yet more encouragement to invest and employ. Yet unemployment remains stubbornly high, productivity is poor and and hours of work are falling.

In the case of smaller businesses - and more generally in Europe, where businesses depend more on bank lending - the problem is the broken money transmission mechanism. The fact is that damaged banks won't lend to riskier prospects, especially when they are under regulatory pressure to de-risk their balance sheets: interest rates on lending to small businesses remain high despite the considerable support extended to banks by governments in the developed world.  QE has provided banks with huge amounts of excess reserves - but it hasn't given them a reason to lend productively. As with corporates, QE simply gives banks an opportunity to shore up their balance sheets and maintain directors' remuneration. Banks, too, tried to spin their lack of SME lending as due to a shortage of good quality opportunities - but NIESR's recent research gave the lie to that.

So the broken financial and corporate transmission mechanisms mean that QE does not reflate the real economy. That alone would make it pretty ineffective. But it doesn't make it actually deflationary. To understand why the fact that it encourages hoarding and risk-averse behaviour means deflation, we need to complete the loop from companies starved of investment to an economy starved of demand.*

It does not matter whether a company is starved of investment because banks won't lend to it, or whether it starves itself of investment through exploiting QE-induced distortions in the financial markets. The effect is reduced productivity, which pushes through to reduced wages. If the cost of capital is such that using low-cost labour is cheaper than investing in machines, unemployment may fall, but so will productivity as workers have to use less efficient tools. Similarly, if it is cheaper to use poorly-paid temporary, part-time, casual and self-employed workers than to recruit full-time staff, unemployment will also fall - but average hours worked will also fall. In both the UK and US we are seeing increasing under-employment and reducing productivity: unemployment is high in both countries, but not as high as it might be if average hours worked were higher. For me this indicates a pattern of low corporate investment in both capital and people.

Under-employment and falling productivity force down real incomes. Add to this the effects of fiscal tightening in both the UK and the US, which hit working people on middle to low incomes disproportionately, and to my mind you have a significant hit to aggregate demand which is sufficient to explain deflation in both countries. Both UK and US governments believe that monetary tools such as QE can offset the contractionary impact of fiscal tightening. But this is wrong. Fiscal tightening principally affects those who live on earned income. QE supports asset prices, but it does nothing to support incomes. So QE cannot possibly offset the effects of fiscal tightening in the lives of ordinary working people - the largest part of the population. In fact because it seems to discourage productive corporate investment, it may even reinforce downwards pressure on real incomes. And when the real incomes of most people fall, so does demand for goods and services, which puts downward pressure on prices, driving companies to reduce costs by cutting hours, wages and jobs. This form of deflation is a vicious feedback loop between incomes, sales and consumer prices, which in my view propping up asset prices can do little to prevent.

Ah, you say, but most people own assets, don't they - through their pensions and in the form of houses. This is true. And it is fair to say that QE props up the value of both pension investments and real estate. But it depresses returns on savings.** Depressing returns is supposed to encourage people to spend instead of save. But when people are saving for their old age, and they see their savings whittled away in the form of below-inflation returns, they are likely to save MORE, not less. They will cut discretionary spending to increase pension saving. This I think is partly the cause of the apparently deflationary effect of QE in Japan. Japan's households have high savings rates because they have to save for retirement as there is no state safety net. In the US and UK the effect may be less, because both these countries have substantial state pension & benefits provision for the elderly. But....those schemes are unfunded, and future taxation may be unable to support claims on those schemes. Therefore governments persistently "talk up" the need to save for old age. It seems likely, therefore, that the combination of increased pressure to save for retirement and depression of returns on savings is encouraging people in the US and UK to increase savings at the expense of discretionary spending too. Once again it seems that the combination of QE with other things is deflationary, though that doesn't necessarily mean QE itself is.

Then there is real estate. Homeowners benefit from Government propping house prices with various forms of QE. This support is explicit in the US at the moment, since the Fed is buying agency MBS, though perhaps less obvious in the UK. But QE supports real estate prices even if only government debt is purchased. The rising price of safe assets pushes investors not just towards riskier investments, but also towards safer ones....most notably prime real estate, which has risen considerably in value. Supporting house prices through QE, coupled with low rate policies that (especially in the UK) have kept mortgage rates for existing borrowers very low, has prevented mortgage defaults and supported aggregate demand. But there is a cost. Rental values are high, which hurts people who don't own property - the young, and people on low incomes. There is little evidence now of wealth effects from property prices increasing spending, as used to be the case prior to the financial crisis: people simply aren't taking out second mortgages to release equity for consumer spending at the moment. Fingers have been well and truly burned, and uncertainty around jobs and income means that people are reluctant to take on more borrowing....after all, if your income is falling and/or uncertain, servicing debt is a constant worry, and taking on more (unless you have to) is madness.

Overall, therefore, QE looks deflationary to me. Or if not actually deflationary in itself, at least completely ineffective as an offset to contractionary fiscal policy and fear-driven hoarding by companies and households. And there is one particularly poisonous effect that I mentioned in passing earlier in this post. The excess liquidity caused by QE, and shortages of the safe assets being purchased, encourages investors not only into riskier assets, but also into alternative safe ones. There is a lot of cash hoarding going on.....and I've noted already that QE drives up the price of prime real estate. It also interferes with the pricing of metals, which has implications for production costs in manufacturing industries. And spikes in the prices of foodstuffs and oil have also been attributed to QE. If this is true, then QE is toxic, because it increases the price of the essential goods that people need in order to live. But as with all things QE-related, it's not that simple....after all, commodity prices are falling at the moment. What is clear, though, is that QE causes enormous distortions in financial markets which are not fully understood and which create fear, uncertainty and instability in the financial system. This could be justified if its effects were evidently beneficial. But it is by no means clear that they are.

From where I stand, QE looks like a very bad bet indeed. The benefits are uncertain and the downside risks huge. In my view it should be stopped. But you may not agree - and I know that many people are much more positive about QE. If you believe that overall its effects are beneficial to the economy, please do comment. Or even submit a post of your own arguing the opposite case.

And here is a final thought. It's all very well criticising QE, but what should we do instead? After all, we have stagnant economies, damaged banks, risk-averse corporates, highly-indebted households, high unemployment, under-employment, low productivity and falling real incomes. Doing nothing is not an option. If QE is a disaster, what is the alternative?

Please do join in the debate by clicking on "The QE Debate" at the top of the screen. This post can be read both here on Coppola Comment and on The QE Debate. 

Related links:

Inflation is falling everywhere - FT Alphaville
Measure it however you like, inflation has been low and falling - FT Alphaville
Estimates of inflation expectations - Cleveland Fed (h/t Izabella Kaminska)
Bank of Japan's quantitative and credit easing: are they now more effective? - Berkman (IMF)
UK retail sales commentary May 2013 - Markit
The fatally flawed FLS - Coppola Comment
UK Treasury Committee oral evidence on QE - Gavyn Davies, Stephen King and Roger Farmer
Electronic money and negative rates - Pieria
The distributional effects of asset purchases - Bank of England
Lessons at the zero bound: the Japanese and US experience - Bernanke (NY Fed)
Executives cash in as cheap debt funds staff buybacks - FT (paywall)
Evaluating changes in bank lending to SMEs 2001-12 - NIESR
Bifurcation in the labour market - Coppola Comment
The financialisation of labour - Pieria
Bank of England must halt QE gilt-buying - Saga

John Cochrane outlines a different argument for the contractionary effects of QE in The Fed and Shadow Banking.

John Aziz recently suggested an alternative to QE.

* We should remember of course that we do not live in a closed world, but the US and UK both have substantial trade deficits and Japan has slipped into trade deficit too. Since the entire world is attempting to increase exports and reduce imports at the moment, it seems highly unlikely that the export sector can make up for lack of domestic demand.....especially since Japan's economy has stagnated for 20 years DESPITE a significant trade surplus for much of that time. I don't think an export-led recovery is really possible for anyone. Domestic demand is the key to recovery.

** Campaigners for the elderly claim that people who are living on the returns from their savings are finding their incomes squeezed because of QE. Some are compensating for this by taking on part-time work, but others are simply cutting spending. This is an obvious hit to demand, although this is a relatively small group of people so the deflationary effect would be small. But I am not convinced that this is a major cause of QE's deflationary effects: I agree with the Bank of England that the main cause of the squeeze on fixed incomes is low rates. The distributional impact of QE is far more complex.


  1. The way I would frame the argument is to say that QE is not what it says on the tin: there's virtually none, or a very small quantity, of actual easing.

    Flipping money-substitute government bonds (or US agency quasi-bonds) for cash doesn't really change the quantity of money -- in a broad sense -- around. This is pretty clear when banks just sit on the proceeds of own-account bond sales as reserves, but it also indirectly happens if someone is say selling their Treasuries to the Fed to buy Apple bonds, which in turn just contributes to Apple keeping a larger bank balance than they otherwise would, which is likely to end up as excess reserves as well (Apple being here used as a proxy for people who are not allowed a central bank account, and it's pretty clear that Apple's investment level is not funding-constrained).

    That said, while some money has been raised for zero sum operations like share buybacks, there's also been some increase in stock issuance (which is unlikely to be used for share buybacks...), it would be nice to try and see what the net effect is like.

    As for the downside risk, there are none to speak of apart from gross operational stupidity. First if QE is indeed nothing much, doing nothing much in reverse will also result in nothing much happening.

    And if there was an inflation problem (for whatever reason), the government/central bank combo has a myriad of tools to sponge back any excess liquidity: tax increases, bank lending rules, and ultimately they can always shrink/freeze/disappear the electronic balances banks have with the central bank. There's no credible situation where that wouldn't be enough.

  2. Having trouble seeing QE being deflationary.Portfolio rebalancing appears to have led initially to refinancing of large corporates via capital markets,easing bank balance sheets and funding costs.Hoarding or share buy-backs have ensued.At bestmisallocation of resources.Credit channel is stuck and broad money weak - to mid '12.QE may have leaked away from real economy. Exchange rate transmission,if anything, would be inflationary. My jury is out on its support for financial asset prices in safe-haven flows and Euro policy errors. Jonathan Portes tells me it has little influence on long term rates. That leaves me with distributional impacts on consumers - counterfactual uncertain in deleveraging shock.Regulatory drivers operating against SMEs.The confidence channel may have initally averted a collapse but wanes now. SHIREBLOGGER

    1. Really the conclusion of the post was "case not proven" for QE being directly deflationary. It's fairly evident that QE doesn't reach the parts it needs to because of broken transmission mechanisms, so can't offset deflationary fiscal policy, household deleveraging and corporate hoarding. But that doesn't make it deflationary in itself.

      However, I haven't talked about the expectations channel yet. Have a look at my second debate with Economist Hulk - we covered it briefly there. If people expect QE to be inflationary when it is not, their behaviour may actually cause deflation. Though again, that doesn't mean that QE is intrinsically deflationary.

      The best argument I have seen yet for QE being actually deflationary, though admittedly on a small scale, comes from Toby Nangle and applies specifically to the UK because of the existence of legacy defined benefit pensions. It's on the Links page, though last time I looked the link was temporarily broken - if it's still broken I will try to get it fixed.

      I also think that in Japan, with an ageing population saving for retirement, QE may be actually deflationary because of the perverse incentive to save more when returns on savings are depressed and inflation expectations raised. If so, Abenomics will make matters worse, not better. It's too early to tell, really, but the consumer price collapse so far does tend to support this argument.

    2. There is so much wrong with your article I dont where to start. Firstly you have to read up on 'Austrian economics''Mises'
      Inflation is NOT rising prices and deflation is NOT falling prices. When QE creates, prints 85 billion a month, how could this possibly be 'deflation'?(your definition falling prices) When the Fed creates money, somewhere in the economy prices will rise. Writers like yourself don't grasp that prices increases will be disorted. Some prices will rise a lot some a little and some will drop.If the price rise was uniform across the board the gig would be up for the Fed and everyone would know to just look at money supply figures and ask for raises in wages, pentions ect. to cover purchase loss. So bottom line counterfeiting only benifits banks,goverments and the super rich, the people that get direct QE money and those super rich that are in the 'know'. I'm getting a few crumbs from following the super rich.

    3. There is so much wrong with your comment I don't know where to start. Firstly, as QE is a monetarist policy you have to read up on Friedman and on the modern-day market monetarists such as Scott Sumner and David Beckworth. Commenters like you also don't grasp that nearly all money in circulation is created by the private sector, not the public sector, and that therefore QE does not increase the amount of money in circulation unless bank lending increases. And there is zero evidence that it increases consumer prices, either. Though you don't like the term used in that way, I was specific that what I meant by "inflation" was consumer price increases - not asset price increases.

      It is also wrong to describe the creation of new base money by the central bank to buy up assets held by the private sector as "counterfeiting", since the central bank is the only institution that can LEGALLY create base money. You clearly don't like the central bank creating money, but that is the central bank's job.

      What I find truly amazing is that after saying I am completely wrong, you then agree with my conclusion - which is that QE only really benefits people with substantial holdings of financial assets, i.e. the rich.

  3. Expectations - the idea that inflation will be increased encouraging the bringing forward of spending? Shaun calls it psychobabble. I think it of not much effect in a liquidity trap with a 2%ish inflation target - Carney would need to do something big. SHIREBLOGGER

    1. I actually think that expectations are far more perverse than that. Expectations of future inflation don't necessarily encourage spending - they may actually encourage more saving to compensate for expected erosion, and investment in inflation hedges such as gold and TIPS. After all, inflation can be regarded as a tax on savings, so it is reasonable to suppose that Ricardian effects might apply. In which case any short-term expansionary effects would be cancelled out by inflation-avoidant behaviour.

      I am going to write about this!

    2. 'Inflationary expectations' has always been a canard: a rhetorical stick with which to beat down wages to the benefit of capital.

      Investors clearly have inflationary expectations - they would not invest otherwise - but in the real world of production and consumption, people look back, at their experience of inflation, when they make(say) wage claims.

      The convoluted rubbish spouted by economists aiming to justify the unjustifiable has reached epic proportions.

    3. You'd expect the Ricardian effects to exhaust pretty quick. Most inflationistas who have some spare cash flow have been fully invested in gold/whatever for years now. Being an inflationista is a pretty binary proposition: I doubt you can find many people who were rabid Keneysians in 2009/2010 who turned into inflationistas like this year because of one drop of incremental QE too much...

      Indeed I'd rather expect a slow drip the other way: weak inflationistas who get tired of waiting for inflation who sell their gold to buy stocks...

    4. There's a whole industry dedicated to talking up the risks of inflation. And there is evidence that QE does raise inflation expectations at least in the short run. I agree that people do seem to get bored with waiting for inflation that never happens, though!

      I'm more interested in why policy-makers apparently think Ricardian effects would apply to short-term fiscal stimulus but not to short-term monetary stimulus. Seems illogical to me.

  4. Any interest coupon the public sector would receive, now, is paid to the Fed, who reverts payment back to the Treasury.

    Is removing this money from the economy, by way of lost interest payments, in itself, deflationary?

    1. Arguably yes, because the effect is to depress returns on savings - as I discussed in the post.

  5. The alternative is for a direct injection of new money into productive infrastructure. Set a NGDP target and away you go. Start with 2% of GDP and monitor the effects.

  6. Forget all this handling of monetarist or keynesian macro-levers. The single most dramatic rupture of transmission is the rigid, blocked labour market of the european latin countries (no dismissals, working only 35 h, enormous wedge on wages, no qualification through apprentceship, etc.).
    Look at Switzerland, no strict regulations, jobless rate of 3,1% overall, 3,2% for youngsters.

    1. This post is not about the European latin countries. It is about the UK, US and Japan. I could have included Switzerland, since the SNB has in effect been doing the largest QE programme in the world to hold its currency peg to the euro. But emphatically NOT the Eurozone. There is not a smidgin of QE there.

  7. Glad to read an economist finally smell the coffee. The effect of QE is quite logical and against the interest of the populace.

    The assumption seems to be we the indebted masses faced by falling wages, indebted and watching the stripping of our future pension income due to rates and bank charges will rush to take on more debt if rates we don't actually get offered are low.

  8. I pretty much agree, but I think you have missed an important deflationary effect which is the reduction in the amount and increase in cost of safe collateral due to QE. This effectively squeezes the shadow banking system and stunts capital flows.As discussed at the following links.

    I do however think you are wrong about QE being out right deflationary.My opinion is that it depends on its size and duration and the base interest rate. It may actually be a useful tool for limiting bubbles during normal interest rate environments.

    The argument presented here about the affects of QE on Commodities seems a little vague. If you take into account the fictionalization of commodities through the likes of ETF's they could become a safe asset substitute, but then so can certain currencies (Swiss Franc) or investment opportunities (China maybe). You end up with volatility as money switches from one form of substitute safe asset to another. Each run up and switch incurs losses which can in themselves be deflationary.

    If QE is deflationary at this point then can we argue that the end of QE would be inflationary. Perhaps removing the shackles from capital flows in the shadow banking system will see vast outflows to emerging economies, forcing currency moves and bankruptcies there.Perhaps it will be inflationary and the Fed will be late getting inflation back under control.

    The idea of unwanted redistributive effects, is probably going to be unpopular in economic circles, because in a way it is arguing that changing sectoral balances has uneven effects in the real economy and you would need specific policy to change the relationships between private sub sectors.

    A possible policy is to print and destroy money based on wage inflation and unemployment operating through reductions and increases in household tax. Potentially this would scare the markets through inflation expectations, and scare politicians because they would not be able to lavish money on pet projects during the good times.With a fixed framework outside of politicians control, with a mandate to both destroy and create money, perhaps it could work if it was sold properly. I think some businesses at the moment would swap a little credit availability for an increase in demand and reduction in pension liabilities.

    1. The effects of QE are far too large a subject for one post, really. So I limited my argument in this post to redistributive effects. Maybe I should have made that clearer!

      The safe collateral issue has been extensively discussed by others, as you note. I will post these links and others at the QE Debate site. However, I am not convinced that QE is the main cause of the safe collateral shortage. I think the biggest collateral supply issues are the failure of MBS and sovereign downgrades, and the biggest demand issues are regulatory changes and the general move away from unsecured lending in the wholesale markets.

      I also did not really address the commodities issue, which is why you find it vague.

      I agree with you that if QE is actually deflationary, we would expect an inflation spike when it ends. Trouble is that it actually hasn't ended anywhere, so we have no counterfactual. However, the UK and Japan charts both show inflation rising a bit when QE stops. Certainly not conclusive (no counterfactual, too much noise), but maybe indicative.

      I am indeed arguing that changing sectoral balances has uneven effects. And I therefore don't think monetary policy alone can support aggregate demand. I think we need carefully-targeted fiscal tools to influence aggregate demand within a monetary policy framework, especially when interest rates are very low. So I'm with you on using taxation as a money supply control when there is little "wriggle room" on interest rates.

    2. I doubt there will be an inflation spike when QE ends after unwinding swollen central bank balance sheet. It spikes interest rate, and negatively impacts equities markets. It is a reverse money redistribution effects to fixed-income assets. It does not provide incentives for more productive goods/services demands for inflationary economic growth

  9. “If QE is a disaster, what is the alternative?” Obvious, strikes me.

    Instead of printing money and stuffing the pockets of the rich, do some more fiscal policy funded by printed money. That’s what Adair Turner, Positive Money, New Economics Foundation, and Richard Werner suggest, and I agree. I.e. print money and spend it into the economy: raise pensions and/or cut NI contributions, cut VAT – the list of possibilities is endless.

    And if that’s inflationary, then there is nothing you can do with conventional tools. There are of course unconventional forms of employment like the “Job Guarantee” which is pushed by advocates of Modern Monetary Theory. That’s a form of employment not a hundred miles from the Work Project Administration type employment they had in the US in the 1930s, which in turn is similar to the various “Job Creation Schemes” we’ve had in the UK over the last 40 years or so.

  10. Frances, another excellent post. To my mind, rather than looking at inflation alone, I would suggest evaluating QE in terms of whether it is expansionary or contractionary for aggregate demand (slightly wider focus). I fully agree with you that QE seems neutral or contractionary.

    The only ways QE can be expansionary is if lots of non-banks look at discretionary expenditure in a mathematical way: "my IRR for this project is 4.2% so if my marginal borrowing cost goes from 4.5% to 4.0%, I'll invest". Economists still seem to think real households or corporates think like this! It's staggering.

    By the way, in case you haven't seen it, the BoE's best attempt to calculate the expansionary impact of QE is here. I don't find it convincing.

    1. Anders,

      Yes, that's a good point about AD, since the whole point of QE is to support it - increasing inflationary expectations is only part of that.

      The fact that households, corporates and banks don't think like that is at the heart of the transmission problem. Throwing money at banks doesn't make them lend: throwing money at corporates that are already awash with cash doesn't make them invest: and throwing money at rich people doesn't make them spend. Throwing money at companies and households that are struggling to survive would undoubtedly make them spend and invest, but the powers that be are so damn terrified of inflation that they don't want to do that. Sometimes I wonder if they really want recovery.

    2. For all the talk of Keynesians gone wild, the truth is that the TPTB are still believers of the outmoded Reagan era supply side economics model-returns to capital at the expense of labor will lift all boats...

    3. QE is a policy for money redistribution without incentives for more productive goods/services spending for economic growth.

      It is crucial to have right incentives associated with a policy. Individuals making rational choices on redistributed money can aggregate into efficient GDP outcomes. Now, the rational choices from private sectors is saving or purchasing financial assets.
      Thus it is a policy flaw rather than human behavior flaw.

  11. If QE isn't inflationary, then we should print enough money to buy all the assets in the world. Then we could live off the income and wouldn't have to work. Wasn't that Bernanke's reductio ad absurdum rebuttal of this argument 10 or 20 years ago?

    1. Your argument does not prove that QE is inflationary. Think it through: the income generated by those assets comes from production, which requires work. If the income is generated entirely by printing money without production increase, the result is inflation. That is not the same as saying that buying the assets themselves is inflationary. Fundamentally, inflation is a flow problem, not a stock problem.

  12. check my simple model of island economy. When people start to save a lot, the required money supply could be magnitudes higher than normal transaction needs, so 4x money supply is quite small amount of easing. QE had some effect, but not enough

  13. It's usually on inflection points such as these that inflation rears its ugly head - not predictably either.

    Maybe it will be in the midst or aftermath of a deflationary crash that federal and monetary policymakers step in to assist. Betting on this is as insane as running an economy on fumes and leverage so the investing public are left to suffer the consequences of a ruinous monetary policy. Such is life in 2013...

  14. Creating money which is not matched by increased economic output does cause inflation, if it is added to the demand side of an economy then it produces inflation of the price of goods but if it is added to the investment side as the government have done with their programme of quantitative easing [QE] then it causes asset price inflation which may be the reason why the stock market indices are rising. The financial bubble itself was a product of the creation of unsound credit which produced asset price inflation and which led to a sudden correction of asset values when the market realised the nature of that credit the government have simply replaced that unsound credit with QE and problematic levels of deficit spending.

  15. Much have been written about QE, but this article certainly is one of the better ones. I view the QE as follows;
    Primary objective ; bail out banks from severe difficulties or default as a result from bad decisions, secondary provide states with the option of issuing bonds at a low coupon, partly used to bail out the troubled financial firms. Any pretext to pretend that QE is designed for anything else is flawed as the central banks are in place to assist banks and ultimately to fund its own government at least temporary. Deflationary/inflationary?, it depends, as all currency is fiat it is the relative values that are relevant. As the velocity of money drops during economic downturns, deflation results from no end demand, reduced income, eventually savings are exhausted etc. QE probably excacerbates this by causing inflation in necessities (energy, food) which benefits from the excess liquidity created. As seen with Japan, these actions lasts for a long time, bad demographics, high and increasing government debt, QE, low interest rates creates a viscious cycle where deflation is the prominent feature. Ultimately the fork in the road will appear, one scenario is where a loss of faith causes a precipitous drop in the currency exchange rate or as a result of currency debasement increased prices of all imported goods (inflation bit) causes distortions which cannot be contained.
    Note* Inflation calculations are often altered, and usually results in lowering official inflation numbers. Common sense dictates that actual inflation as observed by citizens is the price of same basket of food,staples,energy,taxes,healthcare etc. from one year to the next.
    QE is competitive devaluation (alter relative fiat currency values) it does not however work if everybody is doing it. That does not mean they will stop doing it, the effects just slowly but surely disappears but for countries to actually admit that they have been living beyond their means is politically unpalatable so a slow inome/living standard deflation and slow but steady necessities inflation is the method of choice.
    If however the excess liquidity finds it way from bank reserves and out into the real economy, velocity of money roars out of the gates, currency value plummets, no sane investor buys souvereign bonds, prices go parabolic and Hyperinflation Weimar or Zimbawe style has arrived.
    Alternative solution, let failed financial institutions wipe out their stockholders,junior and ultimatly senior bond holders. The government with the assistance of the central bank, protects deposits and maintain a functioning bank system. The recession will possibly be deeper, but likely shorter and organic growth reemerges when the system has been reset and monetary/investment misallocations corrected. If countries can couple this with not thinking they can live beyond their means, much will have been accomplished. Given the existing scoreboard I would not keep my breath.
    As a final remark, if QE is the panacea of the world devised by phD's in economics and if I remember correctly indefinite growth is another, how could this possibly go wrong when planet Earth is most certainly a definite planet with definite resources?

  16. TBTF companies will be so cash rich from QE that they would either 1)retain the money 2)innovate (better technology, less labor needed) 3)buyback shares 4)higher paycheck/compensations 5)donate 6)exit by getting physical real assets 7)get greedy & speculate

    As of current there's two failing systems that's reaching the end of their shelf life. First is the government as a business. Second would be the unfocused education system.

    The problem about the government is that they have yet to develop a method to stop companies from hoarding cash and then redirect the cash back to them. Thus, the cash flows out through the financial market into the hands of other countries which receives the investment from these companies. The only clue the government knows is that they have to find ways to generate higher revenue, enough inflow to balance with the outflow of cash of the country. By not generating enough revenue, government would fail as a business. But even if a balance of cash flow do happen, interest expenses would still destabilize the balance in the long run.

    Education of the current financial environment would turn more citizens to be asset dependent and less income dependent. This would lead to a change of paradigm where getting pay-per-hour would be a thing of the past and people can earn independently through entrepreneur and other financial endeavors. There would also be a huge migration away from the country with a draconian government to a country with more incentives to live in.

    You can see that there is not just the outflow of cash but of citizenship too. This would be the possible scenarios if either system could solve their problem, especially the education system. The financial system which runs on interest wouldn't be called a problem but a predicament already. When the only possible direction interest rates could go is north, the debtor country have to face the music.

    Worst case, both systems could not reach a solution in time. The mass public would have a rude awakening to the surfaced mess that lay before them. Currency gets debased. Failure of everyday businesses. Nevertheless, there's always a faster path towards this outcome. It's when big companies get greedy and lose on their speculation. People won't know where the money disappear to, all they will know is that they've lost money. Compared to this, getting a fine from government seems like a more pleasant experience.

    QE is definitely inflationary unless countries collect those currencies to burn them into ashes. You're making something out of nothing. Even energy can't be created but can only be converted into other forms of energy. I don't see how money is more invincible than energy. Haha.

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  18. Hi Frances,

    Is there a possibility that QEs or similar expansionary monetary policies (but we might be less aware of its existence) were not only initiated in times of economic recessions following the 2008 financial crisis, but far earlier during economic booms pre-2008? Perhaps it's fair to say that in order to sustain economic booms, most nations during the good times, would be and could be reluctant to withdraw their monetary and fiscal stimulus, therefore much of the excess money flew straight into higher prices causing inflation rates to rise. Then when the economy busted, people started to get panicky of inflation more than they were during the good times.

    (I know it's unfair to use the US data, and not a global average of inflation rates to make a comment that refers to "nations", but hopefully there is no a great deal of harm in making hypothetical assumption for the sake of discussion?)

    As we can see from the first graph you presented above, the inflation rates in the US before 2008 were generally higher than after the 2008 financial crisis. Albeit there was a peak in between '08 and '09 during the crisis, the rate generally fell steadily from '09 to '11. The period when the inflation rate was declining, I think (though I could be drastically wrong), was due to inflation targeting by nations, because governments feared stagflation (high unemployment + high prices), which historically had ended many political careers. Controlling inflation is naturally almost every government's top policy objective, most notably China, Germany, and other emerging markets.

    So yes, maybe QEs and its variant policies may theoretically be inflationary, but central banks accompanied by government fiscal policies committed to controlling inflation, are why we see the inflationary effect of QEs is cancelled off.

    On top of that, current slowing down of global economy usually drive up the unemployment rate, rather than the inflation rate. Hence, the overall effect of QEs + fiscal tightening (which include reduction of public spending, capital flows control) seem to be deflationary.

  19. Regarding possible alternatives, I think you answered your own question. Real interest rates need to go up. Way up. If real interest rates are substantially higher, working people and fixed income people do not need to save as much because they can instead count on their future interest income. In the current ZIRP environment risk-averse savers need to set aside as much as they can.

    Of course a spike in interest rates causes a lot of short term pain, which is why it is always going to be unpopular. But that's the choice we're offered: Car accident or cancer? Bankruptcy or zombification. Repentance or perpetual economic purgatory.

    People will say that we cannot endure high interest rates because the debt load is now much higher than it was when Volcker increased rates in the early 1980s. They're right. It would overstress and collapse the system, forcing a reset of epic proportions.

  20. Have we considered the notion that QE has been established more or less with the ultimate goal of ensuring the survival of the banking system? All other concerns are ancillary? It would seem to me that this single focus, getting the balance sheets healthy enough for the broader economy should any recovery get under way, is justification enough for any QE thus far.

    The only question is to what degree QE has impacted all other facets (negatively or positively) and whether on those grounds QE wasn't worth it at all. I can't fathom any situation in which the issues stemming from "main street" are improved by a banking system allowed to fail. The leverage is simply in the financial sector's hands. The transmission mechanisms that we continue to talk about reflect exactly that, banks unwillingness to lend to riskier entities. Imagine insolvent banks impacts on existing corporates....

  21. Cross post from SA:

    This is déjà vu (à la mode de 1966 S&L crisis). Commercial bankers [CBs] pay for what they already own (distributing reserves [IBDDs] across the geography) - then the non-banks [NBs] get the "left overs".

    Excess reserves grew as OMOs were consummated. The money stock would have grown only if OMOs were conducted with the NBs. But it didn't. Only reserves grew. Ergo, the FRB-NY (central bank) bought virtually all of the "specials" [HQAs] from the CBs.

    Gov'ts & reserves can't be "perfect substitutes". SOMA held gov'ts aren't "more liquid" or more "fungible" (as they're impounded by the Reserve Bank via one-way flows). The "arbitrage opportunity" is buying T-Bills at "repressed" rates & then selling them to the FRB-NY for their higher policy yield. Only the CBs can arbitrage this way.

    I.e., the Fed withdrawals liquidity by buying gov'ts - then replaces them with idle, unused, illiquid (non-tradable), & contractionary: IBDDs. I.e., you can't take money nor reserves out of the CB system (unless you hoard currency).

    No, the solution is to reverse the flow of get the CBs out of the savings/collateral business [by lowering the remuneration rate & thereby narrowing the corridor (& arbitrage opportunities), thus reducing the NB’s core retail & wholesale funding liabilities costs].

    I.e., the elimination of Reg Q ceilings was literally a conspiracy (economists are STUPID). The lending capacity of the CBs is determined by monetary policy & not the savings practices of the public. The CBs could continue to lend even if the public ceased to save altogether.

    Note that the pledging & repledging of "specials" doesn't add to the supply of loan-funds (nor the money stock), rather it supposedly "secures" a debt (backing trading & borrowing).

    This course of action would not reduce the size of the CB system, the volume of earnings assets held by the CB system, the income received by the CB system, nor the opportunities of the CBs to make safe & profitable loans.

    Quite the contrary in fact. By promoting the welfare & health of the most important lending sector of the economy (the NBs), the health & vitality of the whole national economy will improve. The aggregate demand for loan funds will expand, the volume of CB “bankable” loans will grow, & so will the CB system, - the Federal Reserve being willing.

    1. I have previously asked you not to use the acronym "CB" for commercial banks as it is confusing for my readers, for whom "CB" means "Central Bank" - since they do not come exclusively from the US.

      You focus exclusively on the US. Banking systems in other countries work differently and it is important to recognise this both in posts and in comments. I also feel that you are abusing my hospitality in using this site to grandstand your campaign for the return of Regulation Q legislation.

      Regretfully therefore I must ask you to re-post this comment without the confusing acronym and without any further references to 1966 or regulation Q.

  22. And just one more thing: I appreciate the acknowledgment of correlative/causative differences and how to best make the proper inference (counterfactuals and all) but aren't we forgetting one other important thing here?

    "So QE cannot possibly offset the effects of fiscal tightening in the lives of ordinary working people - the largest part of the population."

    Perhaps it can ameliorate the tightening to some degree (if this is somehow discernible is another debate I suppose) but are we focusing too much on the Fed and not enough on legislators that choose to ignore their end of the bargain? We are criticizing the Fed for opting to act because those actions may not be working and/or be counterproductive but I salute the Fed for acting when all other institutional bodies have failed miserably.

    Any Macro level analysis of the Fed's effects on market dynamics cannot be isolated from an act or a distinct lack of action on Congress' part. This is especially apparent if the transmission mechanism is faulty and Congress does nothing on its end. I do believe that QE is as much a message to the broader market participants as it is to the Congressional body itself. They have ignored these calls sans the 2009 ARRA and a few members have sought to rebuff such actions by the Federal Reserve.

    Perhaps the Fed sought not to act as it has purely to effect that which it cannot but instead to buy banks time and to give legislators room for action that they haven't followed through yet? It's all speculative which is maddening but I simply cannot adopt the notion that QE1 or QE2 had no affect at all or that it's perpetuating a disinflationary environment. Those are consequences of circumstance throughout the world, not causal connections to the actions of the Fed.

    1. My view is that QE1 was the correct action at the time. Asset prices were in freefall in the aftermath of the Lehman failure, and QE1 propped them up. I'm less certain about QE2, and QE3 I think is worse than useless. I regard QE as a crisis measure - hence my endorsement of its use in 2009. But we are now using it to offset the effects of political gridlock (in the US) and self-inflicted fiscal pain (in the UK). To my mind that is misuse of what under the right circumstances is a useful macroeconomic policy tool. I wrote about this in another post that you may not yet have read:

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  25. Maybe it will be in the midst or aftermath of a deflationary crash that federal and monetary policymakers step in to assist. Betting on this is as insane as running an economy on fumes and leverage so the investing public are left to suffer the consequences of a ruinous monetary policy.

  26. think too. it maybe will be in the midst or aftermath of a deflationary crash that federal and monetary policymakers step in to assist. Betting on this is as insane as running an economy on fumes and leverage so the investing public are left to suffer the consequences of a ruinous monetary policy.