Sunday, December 7, 2008
The Fed has begun a very aggressive program of money printing (that goes by the fancy name “quantitative easing”) and shows every indication of continuing this program into the indefinite future. Chances are that the Fed will err to the inflationary side with this program, raising the prospect of serious inflation emerging at some point over the next year.
As we discussed last time, the Federal Reserve is taking heroic (foolish?) steps by essentially becoming the credit market. Where private participants have stepped away from lending and borrowing in anything remotely close to prior quantities, the US government and the Fed have stepped in to plug this hole.
If this was all that the folks at the Fed were doing, it would be risky enough, but they are doing something even riskier, and for which there is precious little history or precedent to guide them. This goes by the name “quantitative easing.”
You should care about this arcane-sounding economic term, because if the Fed gets this wrong, they will ruin the economy for many years (decades?) to come and quite possibly ruin the dollar along the way. Understanding this dynamic will be essential to answering the question, “When will deflation turn into inflation?”
We will get to that question soon. But first, what is quantitative easing?
I don’t think I can explain it any better than Ira Jersey of Credit Suisse , who recently said, “The Federal Reserve is increasing its balance sheet and now printing money, and that’s all quantitative easing is, printing money.”
Quantitative easing = printing money. There. That’s simple enough.
To understand why the Fed is resorting to printing money, let’s review the entire contents of its toolbox.
Fortunately, this is simple, because there are only two things in that toolbox:
1. Setting the price of money (by lowering and raising interest rates)
2. Setting the amount of money (by putting more into the banks)
Figure 1
Bernanke prefers to use slightly different terminology, saying in a recent speech that the Fed has two arrows in its quiver:
While the Fed can’t push interest rates below zero, “the second arrow in the Federal Reserve’s quiver — the provision of liquidity — remains effective,” [Bernanke] said.