Issue #40: Does the Federal Reserve’s Quantitative Easing Really “Print Money”?
And Does it Drive Inflation in the Real Economy?
Introduction
Perhaps the most frequently repeated statement among all economists is that “inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”1 Hence, on the surface, it makes sense to equate the rapid increase in the Federal Reserve’s balance sheet and the rapid increase in M1 and M2 money supply with the recent highs in Consumer Price Index (CPI) and Personal Consumption Expenditures Deflator (PCE) inflation.
Whenever the Federal Reserve conducts quantitative easing, the mainstream financial media trumpets that the Federal Reserve is “printing money” or “injecting liquidity” into the financial markets.
The figure above shows an important point that I must make, which is that M2 is not the most relevant statistical measure of money. During the GFC of 2007-2008, the year-over-year growth in M2 skyrocketed above 10% at the same time as inflation rates (as measured by the CPI and PCE) sunk into negative territory. If inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output, then the aforementioned phenomenon appears to destroy traditional economic theory. The only remaining orthodox explanation is that, during the GFC of 2007-2008, the “velocity of money” collapsed, so that even though the quantity of money rapidly increased, and output decreased, the “turnover” of the existing money stock rapidly dropped.
However, velocity is an extremely one-dimensional and ill-defined theoretical measure of money that economists have shied away from for decades. The velocity of money is defined only by a mathematical identity (M × V = P × Q) and has never been conceptually defined in a methodical manner further than that. In addition, there has also never been observed a stable relationship between the velocity of money and any other economic variable.2
When describing the different types of money uses back in the 1950s, Abner D. Goldstine and Dick Netzer stated that
to some extent the problem is lack of information … that is, the available measures of changes in [the velocity of money] do not reveal nearly so much about underlying money uses as the analyst could usefully employ.3
Moreover, in June 2000, Alan Greenspan stated that
for a central bank to say that money is irrelevant is the deepest form of sin that such an institution can commit … The problem is that we [the Federal Reserve] cannot extract from our statistical database what is true money conceptually, in either the transactions mode or the store-of-value mode. One of the reasons, obviously, is that the proliferation of products has been so extraordinary that the true underlying mix of money in our money and near money data is continuously changing. As a consequence, while of necessity it must be the case at the end of the day that inflation has to be a monetary phenomenon, a decision to base policy on measures of money presupposes that we can locate money. And that has become an increasingly dubious proposition.4
Hence, the most important conclusions that readers should remember when reading the following section about the mechanics of quantitative easing are that (1) money is a complex, subtle, and elusive topic, one that is not easily defined by any single statistical measure (e.g. M2) and that (2) there are several kinds of money and money-like securities.
I have already described in great detail and depth the significance of the hierarchy of money in Issue #9 of Monetary Mechanics, but here is a brief review for you if you need it:
Central bank money: central bank money is the direct liabilities of the Federal Reserve, including physical cash and reserve balances that are held at the Federal Reserve (i.e. bank reserves), which are counted as a part of MB or M0 (i.e. the monetary base). Only the Federal Reserve can create central bank money. Anyone can use physical cash, but only banks are allowed to use bank reserves (i.e. individuals and businesses would never have direct access themselves to bank reserves).
Commercial bank money: commercial bank money, which is what most people generally consider to be “money,” is the direct liabilities of commercial banks. These generally take the form of demand deposits in bank accounts, which are counted as a part of M1 or M2. Only commercial banks can create commercial bank money.
Non-bank money: non-bank money is the various kinds of money and money-like securities that various economic actors utilize to fulfill financial transactions and finalize account balances but ultimately fall outside of the traditional definitions of money. Examples include high-quality collateral, money market fund shares, and other financial securities. Any non-bank economic actor can create non-bank money, as long as it is acknowledged and accepted as settlement.
In this issue of Monetary Mechanics, I am only going to talk about central and commercial bank money, tabling the various types of non-bank money for a future issue of Monetary Mechanics.
What is Quantitative Easing (QE)?
I have already described in great detail and depth the Federal Reserve’s quantitative easing operations in Issue #7 of Monetary Mechanics, but here is a brief review for you if you need it:
The Federal Reserve conducts quantitative easing in the secondary market with the primary dealers.5 6 It is one type of open market operation (OMO), known as a permanent open market operation (POMO), because its intended effect is not only a short-term modification of the level of reserve balances in the banking system, but also a permanent or quasi-permanent change.
The primary purpose of quantitative easing is to lower long-term interest rates to stimulate borrowing in the real economy, as well as to encourage a “portfolio rebalancing effect,” so that investors and other financial market participants would invest in riskier securities (as the yields of risk-free alternatives are lowered), which would stimulate the demand for riskier financial assets (e.g. corporate bonds and equities).7 8
While the Federal Reserve is only permitted to conduct quantitative easing with the primary dealers, the primary dealers are expected to solicit bids from their clients/customers prior to Federal Reserve purchases, thereby acting as a conduit/channel to the Federal Reserve, but not as the ultimate seller of the US Treasury or Agency mortgage-backed security.9 Since many primary dealers are not a part of a bank, but only banks can hold reserve accounts at the Federal Reserve, there are several scenarios that can occur whenever the Federal Reserve conducts quantitative easing.