Do we really need to fight inflation?

ironchef · May 9, 2024

piezoe said:
You're entitled to an explanation. I've been wrestling with the "simple terms" part however. Instead of writing "QE doesn't cause Inflation". I should have written, "QE is not a sufficient condition to cause inflation." Which leaves a bigger crack in the door to interpretation. In general, QE by itself won't cause inflation. Right now the Fed isn't engaged in QE as far as I know. It seems the Powell Fed is mainly not replacing securities in its inventory as they mature. Proceeds from maturing Treasuries, minus Fed expenses, would flow directly back to the Treasury.

Most Americans, thankfully not all, believe that government finances are just like their own personal finances and the Government must therefore live within its means in the same sense that families must live within their means. They think that when the government spends beyond its revenue it must borrow the difference. This is total nonsense. No nation can borrow in the same currency it prints! It can appear to borrow its own currency, but it's an illusion. The only nations that have real debt are those that are obligated to pay their debt back in a currency they can't print!

The U.S. Congress covers all deficit spending by “printing new money” using the Fed and Treasury as their operating arms. Later the Treasury auctions securities. These auctions give the appearance of the Treasury borrowing from the private sector. All that's happening at these auctions, however, is that a kind of U.S. money that doesn't circulate and pays interest is being exchanged for a kind that does circulate and doesn't pay interest! This exchange of money types, one for the other, alters the way newly printed money appears in the economy but has no affect on the total money in the economy! The Fed will then later, according to its monetary policy, vary how much of the total money in the economy (which includes Treasury Securities too) appears as circulating currency and bank reserves and how much appears as Treasury Securities.

QE is something that's done when demand for money is low and the economy is in recession. We don't have a recession going, so the Fed is not doing QE. The strong economy is helping to drain excess reserves and push up rates, apparently without the fed having to increase their selling of securities much.

It seems QE is regularly confused with money printing. That might be because the term “printing” has a history of being used imprecisely. For example, do you want to call expansion of the money supply due to fractional reserve banking “printing”? I don't. That kind of money (i.e., “inside” or “bank money”) is created by letting more than one entity share the same pile of money since all entities don't need the money at the same time. Inside money is like a magician's illusions. It appears when a bank makes a loan but disappears when the loan is paid off. This temporary money is in fact the biggest contributor to M2, a common measure of the money supply. At present it amounts to roughly 15 trillion dollars, whereas the “money base“, which consists of currency in circulation and bank reserves, is about 5 trillion.

Confusing OE with “printing” may be responsible for the common expectation that QE is going to cause inflation. Even Ph.D. Economists, particularly those that were studying economics 25 or more years ago have often called QE "printing". Bernanke, one of my heroes, said it once, and John C. Williams, head of the New York Fed, referred to QE as "money creation" in a paper I recently read .

QE, because it increases bank reserves, does indeed increase the money base which I suppose could be confused with “money creation”

If QE is not printing, what is it? From my point of view, the term "printing" should be restricted to mean the creation of new money in the economy that did not exist previously and that will remain in the economy unless taxed away. Never mind that some economists still refer to conversion of Treasury Securities into bank reserves as “printing”. They shouldn't do this because it is both wrong and misleading.

The U.S. Constitution gives the power of creating new money, i.e., printing, exclusively to Congress. In the U.S., printing is caused by Congress deciding to tax less than it spends. Operationally it occurs when the Central Bank (our Fed) covers a Treasury overdraft. But it is terribly important to understand that the Fed has no control over the amount of new money created, none whatsoever! New money first appears in the economy as bank reserves because it enters the economy by being spent into it when the Government desires to make transfer payments or purchase goods and services, and the Government's revenue falls short of the expenditure. (The payer or buyer is the Government and the government's agent is the U.S. Treasury. The Treasury's reserve account is at the Fed. The payment recipient, or seller is an entity in the private sector, and the seller's bank also has its reserve account at the Fed. The Treasury's reserve account is debited and Seller's bank's reserve account is credited.)

If, and only if, the Government's purchases cause the Treasury's reserve account to experience a net overdraft, the Fed will step in and see that the overdraft is covered (No treasury check will ever bounce!) In the instance of a Treasury overdraft being covered by the Fed , the Treasury will later auction securities in the amounts equal to its net overdrafts, making it appear as though the Treasury were borrowing from the private sector economy to cover overdrafts. This is only an illusion, because the money seemingly borrowed is actually the new money previously “printed” when the Fed covered the overdraft. What is actually happening when the Treasury auctions securities is the new money that was previously printed and spent into the economy is being changed in form to a Treasury Security! This is the justifiation for why the MMT model, and my own too, treats Treasury's as just an interest paying form of non-circulating money.

Treasuries are not part of Bank reserves and not part of the Money supply, but they are a form of money freely convertible to other forms with absolute liquidity. They do not represent any borrowing whatsoever!

If you are one to think that the Fed is still the old 1913 “Private” Fed then you are bound to remain confused. In fact the Fed today is a nearly, completely different animal than the 1913 Fed. That Fed was reorganized by the banking legislation of the 1930s and is now, for all practical purposes, as thoroughly government as the Treasury. The Treasury and Fed are parts of the overall government money operation whose specific functions have been delineated by statutes with the intention of shielding monetary policy from political influence as much as possible. The proof that they are both a part of the same overall money operation is the money flow. Every penny of Fed profit, after Fed expenses, flows directly back to the United States Treasury.

As mentioned above, the model I use treats Treasury Securities as risk free, interest paying stores of money. They are a part of the total money in the private sector while at the same time not being a part of the M2 money supply. Obviously then, Treasuries can be used by the Fed as a means of temporarily reducing the money supply. They are also not part of what's termed the “money base.” Accordingly, QE simply changes money in the form of securities to an equivalent amount of money in the form of bank reserves, but does not change the total amount of money in the economy. Taxes, on the other hand, reduce the total money in the economy and deficits increase the total. Deficits cause printing! The amount of new money printed is equivalent, to the penny, to the amount of new deficit created by Congress.

Since QE results in no change whatsoever in government or private sector assets. It can NOT amount to money printing. No one who understands this process is surprised, therefore to find that QE ordinarily does not cause inflation despite the fact that QE increases the "Money Base."* (money base = reserves + currency in circulation)

Since QE increases the money base, when the Fed began massive QE in late 2008 many economists predicted massive inflation, some even predicted hyperinflation! These same predictions were all over ET. The predictions were wrong for several reasons including: 1) The predictions were based on the false idea that QE was money printing and massive QE was massive money printing, and would therefore greatly increase the total amount of money in the economy. 2) QE was used when the aggregate demand for money in the private sector, even at near zero interest, was low.

In the wake of the S&P Index crash to the devils bottom (666) in March of 2009, QE caused no inflation! Bernanke bemoaned the fact that, despite record low interest rates and swollen bank reserves demand for credit remained low. The large excess of bank reserves created by Fed QE would have pushed the funds rate to virtual zero. To prevent this, the Bernanke Fed decided to start paying interest on excess reserves. This put a floor under rates.**

From late 2008 to 2012, massive QE increased bank reserves by 1.5 Trillion dollars! Inflation averaged less than 2 % the entire time. Inflation remained low until a combination of Covid transfer payments (sorely needed at the time) in conjunction with covid related supply shocks and fiscal stimulus into what would become a nearly full employment economy resulted in high inflation.

I'm no expert when it comes to the subject of inflation, but I can tell you that supply shocks in the presence of robust demand have played important roles in the major inflations I have lived through as an adult. Our most recent inflation was caused mainly by supply shocks in combination with strong fiscal action. I was critical of the Powell Fed that had begun to reduce its balance sheet when Covid hit. The Fed then reversed course even though it was already clear that the Government was going to step in with aggressive fiscal measures to protect businesses that were shut down and their out of work employees. I thought then, and still do, that the Fed should have paused, but not reversed course. I doubt, however, that the Fed's reversing course was a major contributor to the inflation we experienced.

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*Or, if you're an economist, "Monetary Base". The word "monetary" is one of those perfectly useless, and therefore unnecessary words, like "utilize" or worse yet "utilization"! ) We have much better words than “monetary” or “utilize” available, such as "money" and "use"!

**Today's Fed has eliminated the fixed reserve requirement and now sets a funds rate lower limit by paying interest on reserves and an upper limit via the discount window rate. This is more in line with what other Central Banks have been doing for many years.
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Thank you for your post.

Very educational for this non financial amateur trader.

maxinger · May 9, 2024

Do we really need to fight inflation? - Non traders say YES!

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Do we want to embrace inflation? - Traders say YES!

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Do we really need to fight inflation?

ironchef

maxinger