The latest round of QE brought out the usual inflationists sounding the alarm.
From the prior two episodes of quantitative easing to Operation Twist, each time we've heard dire warnings that imminent inflation or even hyperinflation was just around the corner. Well, you can relax. QE has no ability to cause inflation. If anything it is deflationary.
When the Fed, or any other central bank, engages in quantitative easing, it buys assets, adding to its balance sheet and at the same time adding to reserves in the banking system. It's the intent of the central bank to do the latter. The belief is that a greater quantity of reserves in the banking system will spur lending, which will spur consumption and growth. But, unfortunately, in a weak economy that doesn't happen.
Contrary to popular belief quantitative easing is not printing money. When the Fed buys something like a Treasury, it is removing one asset from the economy -- the Treasury -- and replacing it with another asset -- bank reserves. The change in the public's holdings of dollar-denominated assets is zero. You lose a Treasury, you gain some cash. The cash pretty much just sits there in the banking system or is recycled back into the purchase of more Treasuries.
While it's true that the Fed creates these reserves with a mere keystroke on its computer, this is not inflationary. There has been no net, new creation of financial assets in the economy. QE is nothing more than the central bank changing the composition of the financial assets held by the public, such as fewer bonds or MBS, more reserves, etc.
But QE does remove a tremendous amount of interest income from the economy. Over the past four years since the Fed really started to employ these extraordinary measures a total of $400 billion in interest income has been removed. That's not an insignificant amount. It equates to about $1,333 per person in the United States. What would the economy look like if the Fed sent a check to every U.S. citizen for that amount today? You'd have a significant GDP spike (and maybe even some inflation).
Removal of income is really the main impact from QE. And without rising income it's hard for higher and higher prices to be sustained. That's why we have seen the same pattern following these QE announcements: risks assets rally for a while on the false belief that it stokes inflation, then when those portfolio shifts run their course these assets fall back again. On the flip side, we see bonds and the dollar fall, but rise again once the selling stops. The economy remains weak, in fact, even weaker than it was before QE.
The government surely can create new financial assets (money) if it cared to and give it to whomever it wanted. The Treasury could send you a check for $10,000 and you'd have $10,000 dollars that you could go out and spend on whatever you wanted. If the government did that in sufficient quantity it could stoke inflation, but that's a totally different thing than when the Fed goes and simply manipulates rates and/or changes the composition of the assets held by the public. And that's really the only thing the Fed or any central bank can do.
Nor do the Fed's activities hurt the dollar. This is a constant claim that we always here. Yet take a look at the widely followed dollar index (DXY). Just prior to the Lehman bankruptcy in 2008 the dollar index was at 71. Since then the Fed has taken rates down to zero, engaged in three separate rounds of quantitative easing, implemented Operation Twist, extended its policy accommodation thru 2015 plus many other things and the dollar index is at 80.
The current QE is expected to take about $1 trillion in MBS from the economy when all is said and done. That's a lot of interest0-paying assets to be stripped from the private sector when the private sector is clamoring for yield. The effect will be deflationary, just as it has been in Japan for the past 15 years. Once all the buying in risk assets is finished, prices will fall back down on weak demand so no need to fear inflation from QE. It's deflation that should have us on edge.
