Script: Why QE Failed to Produce Inflation
Yes, inflation in Industrialised nations is far above their central bank’s targets of 2%. and Yes, for the last 15 years, these same central banks have been using Quantitative Easing programs <show meme “printing money” here with US central banker pointer + QE meme> with the aim of increasing inflation…
And yet, in this video, I am going to show you why Quantitative Easing, or QE for short, is not responsible for high inflation today.
So, let’s get into the mind of a central banker <clip 0:59>, and see how they think about inflation, and how it relates to Quantitative Easing.
Central Bankers on Inflation
<clip Bernanke (0:34 - 0:50)>
inflation is very very low which you think is a good thing and normally is a good thing. But, we are starting to get awfully close to the range were prices would actually start falling. Falling prices lead to falling wages it lets the steam out of the economy, exactly, and you start spiralling downward. Bernanke: exactly.
Okay, so the idea is that deflation is bad because deflation might devolve into a downward spiral, also known as debt-deflation.
But, this doesn’t yet explain why we might need QE.
To get to that point, we first need to understand how central bankers think inflation comes about.
<clip BoE 0:06 - 0:18>
The total amount of spending affects the rate of inflation. Too much and inflation can rise as the economy overheats. Too little and inflation can fall as the economy contracts.
Okay, so to control inflation, central bankers believed they needed to control the total amount of spending relative to the productive capacity of the economy.
And how would they go about doing that?
Well, they originally thought they could control spending by controlling the interest rate.
<clip BoE 0:38 - 1:03>
To stop prices rising too fast the bank reduces the amount of spending in the economy by adjusting the cost of money. It does this by setting the interest rate on its dealings with financial institutions. This in turn affects the rate on savings, mortgages, overdrafts and other loans. All of this influences how much is spent and saved and in turn… inflation.
Central bankers call this framework of increasing interest rates when inflation is too high and reducing when it is too low: inflation targeting.
And you know what, after adopting it in the 1990s, inflation in most countries actually became really low and stable.
So, of course, central bankers thought they had completely figured out how inflation works and how to control it with interest rate changes.
And when inflation was low in the 2000s, following the central bankers playbook, they had to reduce interest rates. Sure, house and stock prices were going up like crazy but…. there was no consumer price inflation and so there was nothing to worry about.
Of course, we all know how this story ended:
<tv lips 2007 recession 0:42 - 0:46 + 2:19 - 2:23 + 3:03 - 3:07>
Let’s talk about the speed with which we are watching this market deteriorate. What started in America has now spread to every part of the world. This could be the most serious recession in decades.
and that meant people stopped spending, risking a deflationary spiral
So, the central bankers playbook advice was simple: lower the interest rate charged to financial institutions.
But, soon the problem was these were already at zero and they couldn’t really go much lower.
Why not you might?
The reason is cash … which by its very nature has an interest rate of zero percent. So, basically if central bankers were to reduce rates too far below zero, they would risk a run on the banks.
In central bank technical speak: interest rates had hit the zero lower bound.
And this is when central bankers noticed that while the interest rates they charge to financial institutions had hit the zero lower bound, interest rates on loans in the economy such as mortgages and car loans were still quite a bit above zero.
So, they just needed to figure out a way to get banks to reduce rates on these longer-maturity loans?
The solution they came up with was QE. In practice, it meant buying a lot of long-term assets with newly created bank reserves. This is where they money printing meme comes from.
But for central bankers, this wasn’t really about increasing government spending. Instead the idea was to take long-term assets out of the economy, and replacing them with low-interest rate short-term assets. the price of long-term assets would rise and by implication the interest rates on them would fall.
This makes total intuitive sense right? Massive bond buying with new reserves, increases the price of bonds….
Then, central bankers could just go back to using their old framework of controlling spending relative spending through interest rates. The only difference was that they now did so via both short & long term rates.
However, this begs the question, did this actually work?
To see if financial market prices were actually impacted by QE
And, the good news for central banker is that, in most of these studies, researchers found a substantial impact of QE on asset prices.
So, that first part of the central bankers story seems to hold up to scrutiny.
So, we have now seen that the first part of QE worked according to its intended purpose. But, did it cause inflation? <use slide again> Of course central bankers would say that:
ECB clip: (4:55)
“when we look at the purpose we had which was making sure that the inflation outlook is satisfactory, or at least aims towards a satisfactory direction, I think we can conclude that it has been effective”
And when we look at the high levels of inflation we see today, it sounds very logical.
But, this is the Money & Macro channel. It is not good enough for something to sound logical… So, let’s have a look at what researchers that went through years of QE & inflation data in the industrialised economies found.
and…. the answer is (drumroll)
No…. QE has not been very effective.
Sure, some studies find that it likely had some effect on spending and by implication inflation… but it just was not very big.
Now, you might say these studies were conducted before the pandemic and now we do have high inflation which is just the logical conclusion after so many years of QE.
However, if we just do a simple sanity check using US data, we can see that several QE programs caused the central bank balance sheets to explode multiple times while consumer prices in the USA just kept inflating at roughly the same level.
And it is only now, after a massive pandemic with global lockdowns and supply chain disruptions, that we see higher inflation.
Furthermore, if QE was really to blame, we should also have seen this happen in Japan, where the central bank went on a crazy buying spree while consumer prices just fluctuating around zero percent.
So, yeah, linking our current inflation to QE is a really tough case to make.
What Central Bankers Didn’t Consider
But that does beg the question.. why were central bankers wrong about how much their QE programs would influence inflation?
Well, I think the most convincing explanation relies on the fact that our current economies have become more and more financialized. This means that transactions for financial speculation have become more important.
So, lower interest rates across the board induced by QE likely did cause more spending.
It just did not cause that much extra spending on consumer goods. Hence, it did not cause much consumer price inflation.
Instead, QE caused increased spending on financial assets such as homes, stocks, and ironically crypto currencies. Therefore it caused asset price inflation.
And it are precisely these inflated asset prices that mean that, even with consumer price inflation is at all time highs, central bankers are cautious of pulling back QE. They just don’t want to risk another big financial crash.
But, then if not QE, what is causing today’s inflation? Well, for that I made a deep dive that you can check out here.
Also, even though I kept using the money printing meme in the video. It was just too much fun to resit. But, actually QE is not the same as money printing. Check out this video here why.
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