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Tuesday, May 21st, 2013 |
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Why QE Won’t Create Inflation Quite as Expected
Charles Hugh Smith
In the consensus view, the Federal Reserve’s unlimited quantitative easing (QE3) programs will do two things: 1) boost stocks and other “risk on” assets and 2) generate inflation. The two follow-on effects are related, of course; gold and other hard assets are rising in anticipation of higher inflation. But all is not quite as it seems when it comes to the inflationary effect of creating money. I’m going to cover a lot of ground here so buckle up and grab your favorite stimulating beverage. Let’s use some examples to illustrate key features of the relationship between money creation and inflation. Let’s say a central bank prints $1 trillion in cash currency, digs a big hole and buries it. Does that $1 trillion in new money cause inflation? No, because it never got into the hands of people who might trade it for goods and services in the real world. Recall that the premise of monetary inflation is straightforward supply and demand: when money is abundant and goods are scarce, the price of goods rises as abundant demand (everybody has lots of cash or credit) meets limited supply (limited oil, gold, grain, etc.) in an open marketplace. Let’s say the Fed electronically creates $1 trillion and metaphorically buries it in some account where it sits as “dead money.” It cannot trigger inflation because it isn’t reaching the hands of people who might use it to buy scarce goods and services. Let’s also recall that money is destroyed, not just created, when assets fall in value and bad debt is written down. Consider a house purchased for $350,000 at the top of the real estate bubble with a $50,000 cash down payment and a $300,000 mortgage. The owner defaults and the house is sold for $150,000. The $50,000 down payment was cash; it was not “on paper.” It has not been transferred to someone else; it has vanished. The same can be said of the $150,000 the bank lost on the mortgage. The bank’s cash reserves (capital) take a $150,000 hit. That was real money, too, and it wasn’t transferred to someone else; it disappeared. Thus $200,000 of real money has been destroyed. To the degree that immense overhangs of bad debt are slowly being written off, money is being destroyed. If the Fed “prints” $500 billion a year, and write-downs erase $500 billion, the money supply hasn’t expanded at all. The Fed bought $1.1 trillion in mortgage-backed securities as part of its earlier QE interventions in 2009-10. Notice that the $1.1 trillion has already fallen to $850 billion–a decline of $250 billion in just a few years. The loans were paid down, paid off or written off.
According to the Balance Sheet of Households (federalreserve.gov), home mortgages have declined from $10.3 trillion in 2009 to $9.7 trillion in 2012. Credit is being destroyed in the primary asset of the American household, their home: one-third have zero equity (underwater), millions more have insufficient equity to borrow against/extract, and millions more are not creditworthy enough to borrow more, even though they have equity in their house. The decline in asset values has destroyed money and credit. The general assumption is that the Fed buys dodgy MBS from banks which then take the money and dump it into the stock market, pushing stocks higher. This assumption fails to consider the weak balance sheets of banks, which will soon be required to post some collateral behind their trillions of dollars of outstanding derivatives. The favored collateral is U.S. Treasury bonds, and so banks may be constrained by their need to build reserves against future writedowns. They may end up buying Treasuries as collateral rather than gambling in the equities market. The newly created money may end up as “dead money” in reserves, not cash propping up equities. A number of indicators suggest money is not flowing into hands which might actually trade it for goods and services. Consider money velocity, courtesy of Chartist Friend from Pittsburgh:
The velocity of money buried in a hole is zero. The velocity of hoarded money is also zero. The velocity of credit that is never used (i.e. no money is actually borrowed and spent) is also zero. Money that is created but which has zero velocity cannot spark inflation. If money were flowing into real-world households, we’d expect to see household incomes rise. Instead we see falling incomes. Here is the real (adjusted) income for the 45-54 year old age bracket, when lifetime earning tend to peak (courtesy of dshort.com):
Ouch. Income, Poverty and Health Insurance Coverage in the United States: 2011 According to the Census Bureau, “In 2011, real median household income was 8.1 percent lower than in 2007.” If there is net expansion of the base money supply, it isn’t finding its way into household incomes where it could be spent on real goods and services. As for the “wealth effect,” it only affects the 5% who own enough equities to make a difference. That narrows the whole “wealth effect” to 7 million people out of 142 million workers.
Interestingly, the top 5% is the only demographic that is actively deleveraging, i.e. reducing debt rather than borrowing more:
Add all this up and here’s what we get: money is not just being created by the Fed, it’s being destroyed by declines in asset valuations and writedowns of impaired debt. Credit may be expanding but the top rung of households is paying down debt, not borrowing more, and the bottom 95% are unable to add much to their already staggering debt load. Incomes are declining, providing a smaller base for both spending and borrowing. The top 5% may be experiencing a “wealth effect” as stocks soar but 7 million people cannot levitate the entire $15 trillion U.S. economy much while the incomes of the 137 million other workers are stagnant or down. Money velocity is plummeting and banks are hoarding Treasuries as much-needed collateral. It’s difficult to see how these forces could generate inflation. There may be new money and credit being created, but very little of it is flowing to households whose spending in the real economy drives inflation. New video program: The Federal Reserve: Flawed Premise, Mistaken Role:
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v.8
That’s nonsense. We’re going to have hyperinflation like Germany had in the 1920s. The rest of the world is waking up and they’re making agreements to trade with each other in their own currencies.
QE forever = Bad Hyperinflation. Food and gas will go up. Instead of lower job pay, and making us work long hours like in SPAIN. (thats why their protesting.)
No on will make ends meet and everything around us will go up instead.
I have been pondering this for some time. While it is true of the MBS purchases (as long as the assets are held by the fed), there is a flaw in the money burial theory. When the fed buys up US treasury paper, it gives the government “real cash” which it in turn puts it into the general money supply.
What you’re not considering in your analysis above is that the money doesn’t just go to stocks, but also into commodities. This is in part why the prices of food have been going up. The money also goes to other markets around the world which has caused inflation.
if the money truly went into a hole then it would do no good to print it. This is why the Fed pays the banks interest on the reserves – so they won’t go out and spend it. This is a practice that they’ve considered ending by the way.
Down payments don’t vanish. The bank keeps it. Also, some mortgages have mortgage insurance which would reimburse them for the $150,000. Many mortgages are sold off by the banks to Fannie and Freddie. A form of insurance is taken out against those as well. This is why AIG needed a bailout.
Also, some top analysts are suggesting that stocks are better than bonds. So, there is good reason they’d use stocks and commodities.
You’ve got some good stuff above, but you’ve missed a few key points as well.
Thank you for the article, it helps explain to me why all this money creation hasn’t had the effects I was already expecting. I believe the only thing not addressed was what happens when people/countries lose faith in the dollar as a currency. Some of that is now going on with the petro-dollar collapse (countries trading between themselves in their own currencies).
When the dollar is seen as toxic or not necessary, the dump will commence and create at least super inflation. Our prices have doubled in the last 4 years, even everything stays the same gas will be $8 a gallon in 4 more years. But usually these things are exponential and the doubling will take half as long, so 2 years for $8 gas and chicken soup which was 50 cents 4 years ago will be $2.
Throw in a iraq war, oil embargo, or food riots leading to marshall law and all bets are off.
Rich is correct. The freshly printed monopoly money will create a commodity bubble. Go shopping, you’ll see that the 2% inflation reported is a farce because it doesn’t include energy or food costs. Couple that with the chemtrail initiated drought, and a steak dinner will be enjoyed by the uber-wealthy only.
All of the money is not in the Usa but all over the world. We have choices othet countries do not about what to buy. For instance if potatoes are expensive one week we can buy rice.