QE over? Brace for inflation.

Lots of people began worrying about inflation when the Federal Reserve began QE back in 2008. Some even predicted “inflationary disaster,” warning that the monetary base cannot quintuple without a correlating rise in consumer prices.

For a while, I believed these guys. I was an undergraduate economics student at the time, and their logic made sense to me. Increasing the money supply will increase nominal prices, right?

Not quite. It’s true that increasing the supply of money will increase nominal prices, but QE didn’t increase the money supply, per se. It’s immediate effect is to increase the level of base money, which doesn’t change the supply of circulating money. What matters for price inflation, of course, is circulating money.

The reason we didn’t see the type of inflation these inflation-hawks warned about is because the new base money did not increase the M1 money stock (circulating money) like they predicted. They didn’t account for the Fed’s ability to control the rate at which this new money raises the M1 money stock via the interest it pays on base money accounts. And of course, the Fed has every incentive to keep inflation under control.

I’ve written about this before. When the Fed creates money, they don’t inject it into the economy with the intent that it has an immediate, proportional effect on consumer price levels. They deposit the new money into banks’ accounts at the Fed, where it collects interest. This has the effect of increasing bank reserves relative to the M1 money stock. It’s up to the banks, then, how they use these levels of reserves to increase lending activities and grow their balance sheets. By and large, banks have been quite conservative in this regard.

To put it simply, what these inflation-hawks should have been watching was not the amount of QE or growth in the monetary base, but the rate at which base money sparks more lending. That rate has been pretty low.

Now back to the title of this post…

The reason QE’s end should raise inflation fears is because, on the margin, banks will begin lending more to make up the difference from revenue lost because of QE’s end. For years, these banks’ reserve accounts at the Fed have been growing and earning interest. Now they’ve stopped growing (though they still earn interest).

Of course, banks don’t necessarily have to make up this difference. It’s just base money, and big banks aren’t anywhere close to being reserve-constrained. But as I said above, this tendency will happen on the margin. Not every bank will increase lending, but their incentives have now changed in favor of more lending and less hoarding.

I think the reason why we should fear inflation more now that QE is over is clear: Banks have less incentive to hoard cash in their Fed reserve accounts, as these accounts will now grow at a slower rate. The only way to make up this difference is to invest elsewhere. This will have the effect of turning base money into circulating money more often (technically, this is an increase in the M1 money multiplier, which we indeed saw every time QE ended in the past six years).

But prices respond to more than just changes in the money supply. These extra-monetary influences are likely to be stronger in the short-term—especially the appreciating dollar. So I’m not saying to brace for hyperinflation next month, or even any inflation next month. These things take time. Price inflation always lags behind monetary inflation. But I do predict that banks’ propensity to lend will increase, ceteris paribus. This type of inflation–not price fluctuations due to things like fluxing foreign demand, appreciating dollar, etc.–is what matters from a business cycle perspective, and what drives robust, sustained, real monetary inflation in the long term.

Banks don’t “lend out” excess reserves

I recently came across this S&P report by S&P’s Chief Global Economist Paul Sheard debunking common misunderstandings about the Federal Reserve, QE and excess reserves. I’m posting it here to clear up misinformation about what banks do with their excess reserves at the Fed. I’ve definitely been led astray in the past by economists regarding this matter.

The key point, however, is that the existence of excess reserves in the banking system does not loosen any reserve constraint on the ability of banks to lend because there was no reserve constraint to begin with (of course, the stance of monetary policy, notably the interest-rate policy decision, does affect the demand for bank lending and the willingness of banks to lend, but, to repeat, given the interest-rate setting, the central bank supplies whatever reserves are demanded).

It might be asked: if banks cannot lend the excess reserves that the central bank provides, what is the point of the central bank supplying them? The answer to that question is simply that QE does serve to ease financial conditions. Technically, QE allows the central bank to change the composition of the aggregate portfolio held by the private sector; the central bank takes out of that portfolio the government debt and other securities it buys and replaces them with reserves and bank deposits (the latter when it buys assets directly from the public or its nonbank financial intermediaries) (10). This has an easing effect via so-called “portfolio rebalance effects,” including but not limited to the associated downward pressure that QE puts on the yield curve (11).

When the Federal Reserve buys treasuries via open market operations, they credit the sellers’ accounts at the Fed in order to complete the transaction. This drives up the level of excess reserves participating banks have on account with the Fed. These reserves will never be lent out unless, for some strange reason, banks start handing out cash whenever they lend. This doesn’t happen because, as Sheard explains earlier in the essay, banks create credit out of thin air–not out of reserves. As he explains, “Loans create deposits, not the other way around.” The only way for reserves to shrink is for the public’s demand to hold physical cash increased.