For example, let’s say a country only produces widgets, the market
determines their price to be $1, and this creates demand for 1,000 widgets.
Next, let’s assume that the supreme commanders of the country, Lords Krugman
and Bernanke, decide to miraculously double the amount of money held in the
bank accounts of the widget consumers. These consumers feel rich and start
demanding more widgets.
However, nothing else in the economy has changed. Manufacturers are still
producing just 1000 widgets. The resources and technology of the economy are
completely unaffected by the appearance of more money. So if these “rich”
consumers start demanding more widgets, but the manufacturers are producing the
same amount as before, the price of widgets will start to rise. And suddenly we
have inflation, with no increase in real Gross Domestic Product (GDP), the
only real measure of actual production in an economy.
The same inflation occurs when the Federal Reserve simply adds
currency to the US economy. This is exactly what the central bank has been
doing with their controversial “quantitative easing” (QE) program, in their
desperate bid to manufacture a recovery from the never ending
recession of 2008.
The first phase of the ’08 bailout
intervention - called “active monetary policy” - involved keeping short term
interest rates artificially low, (by purchasing U.S. government bonds), and
acquiring more public debt (in order to infuse more money, or in econ speak
“liquidity”, into the market). However, this intervention proved impotent in
the face of near 0 or even negative real short term interest rates, leaving no
room for further economic “stimulation.”
So
the Federal Reserve then adopted a measure called quantitative easing (QE).
This involved targeting the longer term interest rates by purchase of financial
assets from commercial banks. The Federal Government currently holds $2.054
trillion worth of such assets, but intends to taper off active purchases by
October and let the existing assets expire as scheduled.
Two key questions surface:
- GDP has not expanded significantly since the end of the recession, so why are we not seeing the inflation we would expect from so much additional money being dumped into the economy?
- What will the consequences of the end of this expansionary monetary policy be?
To answer the first question, the Federal Reserve Bank pays interest on
reserves held by banks. It has cleverly set this payment at a rate marginally
higher than what the banks can expect to make by lending money to consumers.
Thus, the Fed has incentivized banks to sit on this additional liquidity and
keep the currency from ever really seeing the actual economy. Thus, no
hyperinflation.
Since it doesn’t “cost” the Fed anything to keep printing money
and paying interest to these banks, this is likely to continue even when QE
officially expires,
in a bid to prevent the extremely high inflation that would occur if all these
built up reserves were released into the economy. After October, the Fed will
likely start selling its stock of government debt in the market to soak up this
liquidity. What exactly was the point of this money shell game? Even if
we are doomed to end up where we started, the Fed
evidently feels better to have been busy moving money around.
When the Quantitative Easing plan expires, the Fed has given the
markets enough notice that we are likely to see a only a soft deflation in both
asset prices and the stock market as people start pulling money out to take
advantage of higher interest rates. This should not ultimately effect the real
economy, since the infused liquidity was not actually in play in the first
place. However, since markets and economies are affected by public perceptions
in the short run, I would expect some negative but temporary swings throughout
October.
---Abir Mandal, PhD Candidate, Clemson University Department of Economics and Palmetto Policy Forum Summer Fellow
