The goal of the Federal Reserve's quantitative easing program is to cause inflation.
To facilitate that, the Fed first must discover the price point for debt capital that attracts borrowers to borrow again. The process requires steadily lowering the cost of debt capital. Until the process successfully causes an increase in borrowing, lending, consuming and investing, the result of decreasing the cost of capital is deflationary, not inflationary.
This is similar to the process of price discovery that all goods and services go through on a continuous basis. The difference with respect to quantitative easing is that it is implemented when the economy is already slowing and going through a period of disinflation and toward outright general deflation -- a contraction in the economy. QE is implemented when the normal and continuous process of price discovery that all goods and services go through on a regular basis is not functioning. In this case, not functioning means that the spread between the rate lenders are willing to lend at and borrowers are willing to borrow at do not intersect because the bid-ask spread is too wide. The result is a standoff between lenders and borrowers that causes economic activity to grind down.
Without Fed intervention, the natural course of action is for the spread to widen, causing even less borrowing and lending in what is referred to as a pro-cyclical process. The Fed's job is to reverse this process in a countercyclical fashion by forcing general interest rates down to the point where loan rates meet the rate at which borrowers are willing to borrow.
In reality, the Fed is releasing even greater deflationary forces upon the economy as a means of ultimately reversing the economic slowdown and causing inflation. This process is causing confusion among many investors who have been programmed to believe that when the Fed expands its balance sheet by increasing the quantity of Federal Reserve notes and swapping them for U.S. Treasuries or agency debt held by member banks, inflation is the immediate result.
This is not true.
The only thing the Fed has accomplished is to lower the cost of debt capital to the economy. Inflation can only result if lenders lend and borrowers borrow at the new lower cost of capital. Until that happens, the Fed is actively causing deflation.
If this process takes too, long there is a real risk that the Fed's actions will help to condition consumers, investors and borrowers to postpone action as they anticipate that the cost of capital will fall further in what is known as the paradox of thrift. That is at least partially what has resulted from the four years of zero interest rate policy, or ZIRP, and the Fed's previous limited interventions of quantitative easing.
The Fed's announcement of open-ended quantitative easing targeted at the mortgage market announced is most probably indicative of the realization that its actions have had a pro-cyclical, rather than countercyclical, impact on the economy. Although I continue to believe that 30-year fixed-mortgage rates are going to be dragged down further over the next 12 months, the process of real recovery for the economy is also now finally in its nascent stages.
