This post is a slightly-modified excerpt from a recent TSI commentary.
The Federal Reserve has monetised a few trillion dollars of bonds over the past seven years without creating much in the way of what most people call “inflation†(a rise in the general price level). How could this happen?
One popular explanation is that the Fed’s Quantitative Easing (QE) adds to bank reserves, but not the economy-wide money supply. According to this line of thinking, the ‘money’ created by the Fed to purchase bonds remains trapped in reserve accounts at the Fed. However, this explanation can be immediately eliminated, because as previously explained every dollar of QE adds one dollar to bank reserves at the Fed AND one dollar to demand deposits within the economy. The fact is that the economy-wide money supply is now a few trillion dollars larger thanks to the Fed’s QE.
A second explanation is that QE isn’t “inflationary†because it involves the exchange of one cash-like instrument for another. This explanation can also be immediately eliminated due to the fact that it mistakenly conflates two very different things — money and debt securities. If you don’t understand the difference, try buying something with a T-Bill. You should then understand. Also, more information on this particular issue can be found in my 9th May post at the TSI Blog.
As an aside, QE is not only NOT an exchange of one cash-like instrument for another, it involves increasing the amount of cash in the financial system and simultaneously decreasing the amount of financial assets that can be bought with cash. That is, it results in more cash ‘chasing’ fewer assets.
A third explanation is that the increase in the money supply stemming from the Fed’s QE has been offset, in terms of effect on the general price level, by a decrease in the velocity of money. This is yet another explanation that can be eliminated, because changes in “money velocity†never explain anything. The reason is that money velocity (V) is nothing more than a fudge factor that makes one side of the tautological and practically-useless equation of exchange (MV = PQ) equal to the other side. It exists in academia, but not in the real world. For more information on the irrelevance of money velocity, refer to my 10th June post at the TSI Blog.
