The Reason That Quantitative Easing Won't Cause Massive Inflation

I think that a lot of people who expect that quantitative easing of the amount the Federal Reserve is currently engaging in will lead to a large outbreak of inflation is that they assume that monetary velocity is a constant. We know that, empirically, it is not. If velocity was a constant, increases in money supply would lead to matching increases in nominal GDP, which, if not supported by gains in real output, would lead to a corresponding increase in the price level.

However, in the current environment it appears that the damage to monetary transmission mechanisms was so severe that large increases in money supply simply just sit around and don't actually make their way into the economy. The same thing happened in Japan after their real estate collapse where no amount of easy money policies would cause inflation.

The above chart is related to M1, but here is an alternative measure (MZM) which includes a broader measure of money supply.

Japan had a similar case during its slide into deflation:

This is the nature of a liquidity trap in that no increase in money supply will help because all that will happen is that velocity will continue to drop as there is no demand for money. If velocity drops by amounts sufficient to offset the increase in money supply, no inflation will occur. As of right now, this pattern seems to be holding.

On the Fed's Lending to Financial Institutions

I was forwarded this link today: http://www.thinkbigworksmall.com/mypage/archive/1/55002/

I think one of the misconceptions in most discussions of the Fed's interventions during the financial crisis was that they simply handed this money out and it was never heard from again. In some cases that was what happened, but for the vast bulk of it these were short term liquidity facilities that were repaid in short order. This isn't as though the U.S. Treasury issued $3.3 trillion in bonds, wrote checks to a long list of domestic and foreign institutions, and sent them out.

The overall size of the Fed's interventions was a function of the magnitude of the crisis, which paralyzed nearly every conventional lending channel during the worst of the panic. The Fed stepped into the breach and lent out money in a nearly panicked way in which it seems that it extended aid to all comers. Having followed the credit markets very closely at the time, they were so broken that municipal issuers even couldn't take their issues to market reliably, which is actually astounding. In that environment, it is easy to understand how vast amounts of Fed lending occurred.

As far as the lending to foreign institutions, the financial crisis not only paralyzed markets here, but around the world. The Fed is one of the few institutions (the only other two being the ECB and the Bank of Japan) with the resources necessary to backstop not only our own financial markets, but those around the world. As to whether or not it should be in this role, that is a legitimate discussion, but it is also one that inevitably ends in the argument that it was necessary. I'm not sure that those that have it in for the Fed will ever fully appreciate just what we were facing back in late 2008. Not every action undertaken by the Fed or the Treasury was necessary or correctly handled to be sure, but I'm willing to give a pass on the errors given the alternative.

In general, these nominal numbers get thrown around as if there was a transfer of that magnitude to executive compensation of these banks or to the bottom lines of those institutions. Nothing of the sort happened. I remember when there were headlines that combined the value of the guarantees issued on deposits with the short term lending facilities of the Fed and the value of TARP to arrive at a $13 trillion bailout. The next logical thing for people to say was "They've taken out $13 trillion of the taxpayers' money and given it to the banks!". None of that was the case, but it made for good outrage. That being said, I'm all for questions being asked over why specific loans were approved. That's fine and we may find cases where the Fed was in error and their internal control procedures failed. I have nothing against that. However, looking at the totality of the Fed's actions, I do not find fault with them.

Now, on a somewhat related issue, that is not to say that the approach taken in the aftermath of those dark days has been sound. The lack of fundamental reform has been disheartening and there were very weak efforts to ensure that the emergency relief would be used entirely for the preservation of the firms rather than the enrich the executives of those firms at the same time. Frankly, all officers of every firm that got assistance should have gotten nearly zero pay and been forced to pay back their bonuses for prior years since they clearly did not deserve that compensation. To some extent, this is the fault of hopelessly complacent shareholders who accept every proposal from the board of directors without question. However, given that our government and others had to provide such massive assistance both through the central banks and through programs such as TARP (which has to be viewed separately), the onus falls on them and the taxpayers to demand concessions and inevitably that did not happen.

It could be argued that because the Fed got us through the worst of the crisis and avoided complete disaster, we no longer have the leverage to make the changes that were needed and the impetus for true reform has been lost. In the meantime, it appears that the anger of a public increasingly weary from recession and high joblessness is being misdirected at the institution that saved the world from utter collapse rather than the actors who caused the world to get to that point in the first place.

Quantitative Easing Explained.... By Sane People

This isn't as silly as the much more popular version that was made by Austrian (school) economists/Tea Party/etc idiots, but it is fundamentally much more correct.

The crazy(?) bond rally

Over the past four weeks or so, the bond rally has become truly epic. I have been truly stunned by the magnitude of it.

Here is the oft-mentioned TLT, which tracks the 20 and 30 year US Treasuries.

It's charted against SPY (the S&P 500 proxy) and EEM (the emerging markets proxy). To show that the bond rally has some breadth, let's look at municipal bonds as well. Now, the MUB is not just a long maturity municipal bond fund but rather a larger aggregate so its moves aren't as dramatic, but it tells a similar tale.

The same had also held with corporates, as represented by LQD, which tracks long term investment grade corporate debt.

Now, the question that many are asking is "Is this a bond market bubble?" Well, current interest rates do seem absurdly low. In terms of the stock market, it would be the equivalent of paying 40x earnings for a company's stock (the equivalent of a 2.5% earnings yield). However, with inflation also at historic lows, the bubble might not be as big as some are claiming. If you are of the view that inflation will soon accelerate to 4%+, then yes, bonds are dramatically overvalued. If you believe instead that inflation will be between 0% and 1.5%, the overvaluation of bonds ranges between not much and only marginally overvalued. I do happen to think that, when you look at comparative stock market measures, bonds are at least moderately overpriced. That holds true so long as corporations will be increasing their earnings even at a moderate pace over the next several years.

With the Fed possibly embarking on more quantitative easing (the direct purchase of treasuries to increase the money supply), one might wonder if interest rates will be capped at these low levels or even drop further. The last time the Fed did a similar action, interest rates rose anyway because market expectations of an economic recovery picked up. At this juncture, it's hard to say which way they will go, but I think that past performance might be a decent indication. Quantitative easing is a powerful stimulative tool and if the Fed is zealous in its application, it actually might actually have the net effect of increasing interest rates through market expectations of higher growth. All of this remains to be seen, however.

Brief Thoughts on Fed Action Today

I had a couple brief, and these will actually be brief, thoughts on the Fed's action today.

I don't think the announcement that they will be reinvesting maturing MBSs in Treasuries is actually that substantive as it basically means that the Fed simply is forgoing an otherwise scheduled balance sheet contraction that would have slowly removed liquidity from the system. While that's good, it isn't overly stimulative compared to our current situation except to say that it means we won't have dramatically tightening monetary policy in the near future.

More important than the actual announcement is that the Fed recognizes that economic data has softened notably since May and that the specter we face now is deflation rather than inflation. They didn't explicitly state that deflation is a concern in the FOMC statement today, but implicitly that was there. The key here is that we had to see that the Fed was willing to do more and I was somewhat satisfied that they did. This is good for stocks on two fronts and bad on one. The positives are that the Fed will remain stimulative, helping economic growth and, by extension, earnings. The other is that by buying long term treasuries, interest rates will be depressed, helping stocks appear more attractive as an investment. The bad news is that economic data is weak enough to warrant these actions, which is bad for the earnings outlook, though we haven't heard much from companies indicating that they expect to be taking down estimates. We shall see...

EDIT 8-12-2010: The market certainly seemed to hone in on the third point I broached which is that we only got to this point due to weak economic data and the specter of deflation. I suspect over the next couple weeks that this will be the main focus of the market and every sign of deflation will be greeted with severe trepidation.