After more than a year of economically ruinous lockdowns, many governments in the West have been spending record amounts, increasing fiscal deficits to dizzying levels. At the same time central banks have been engaging in Quantitative Easing (QE), a policy used by the U.S. for the first time in the Global Financial Crisis of 2007/8. It is a policy which has, to put it mildly, raised a few eyebrows due to the huge money creation involved with it. Indeed, concerns of runaway inflation have been about since QE was first used in the U.S.
Inflation and QE
Inflation in the prices of goods and services can occur when money is created and the available goods and services in an economy do not expand to match this increase. More money is chasing each good, and prices will eventually rise to reflect this.
Large money creation can occur when a government wants to finance its expenditures, but can’t raise enough money from tax revenue or borrowing. Many central banks, including the Federal Reserve (the Fed), have laws and rules to prevent governments using them to finance their fiscal spending- history has shown the devastating inflationary consequences it can have.
When a government cannot finance spending through tax revenue, it must borrow money from others. It does this through issuing bonds. Bonds can be issued and bought by domestic investors (ranging from big banks, pensions, hedge funds and others) or foreign investors (including foreign central banks). Inflationary concerns can come about when, instead, the government itself (via the central bank) creates money to buy these bonds and so funds government spending. When QE was done for the Global Financial Crisis and for COVID-19 lockdowns, because it involved the Fed buying huge amounts of U.S. government bonds, concerns of runaway inflation began to bubble, even though QE was, ostensibly, a policy used to stimulate economic activity by pushing interest rates down.
QE by the Fed involved the purchase of around $2 trillion worth of U.S. government bonds in response to the Global Financial Crisis. For COVID-19 lockdowns, bonds worth over $2.5 trillion have been bought by the Fed, and these purchases haven’t stopped yet. Coinciding with these bond purchases over the pandemic, trillions of dollars have been spent by the U.S. government.
The prospect of high inflation
But does the U.S. have anything to worry about? After all, inflation (in consumer goods, at least) had been subdued in the 2010s since QE was first done. Those warning of high inflation from QE ended up looking silly to many.
To analyse the situation, looking at where the created money ends up can help. When commercial banks entered the Global Financial Crisis, they were extremely leveraged, meaning that they lent out a lot of money backed by not much capital. QE helped to stock up these commercial banks’ balance sheets with capital, as the Fed created swathes of new money and then purchased assets like U.S. government bonds and mortgage-backed securities (these are groups of mortgages) from these commercial banks. This can be seen with the large increase in reserves that commercial banks now hold at the Fed; much of the newly created money that the Fed used to buy assets was placed by commercial banks at the Fed as a deposit, at levels greatly above what was required by regulation.
Hence, a lot of this created money ended up, in a sense, locked-up as reserve balances at the Fed and on commercial banks’ balance sheets (as an asset). The money largely didn’t end up in the wider economy.
Enter 2020 and 2021. The fiscal deficit of the U.S. government is much bigger than it was in the aftermath of the Global Financial Crisis, and the government needed (and still does need) to do a lot of borrowing. QE was exercised by the Fed once again, and even more U.S. government bonds have been bought.
This time QE doesn’t seem to have just helped stock up commercial banks’ balance sheets. Now it seems to have funded fiscal spending on, for example, (repeated) stimulus checks. Recently, the U.S. Senate passed an infrastructure bill worth $1 trillion dollars, and again this large spending coincides with the government’s purchases of U.S. bonds through QE. The created money has now found a mechanism to get into the wider economy, as it has ended up straight into individuals’ bank accounts and spread throughout the wider economy.
An indicator of this occurring is the large increase in measures of broad money supply like M2 (which can be seen here) in the past year or so. These increases were not seen when QE was done for the Global Financial Crisis but have been large in 2020 and 2021. A large increase in M2 for the U.S., as has happened, is not a good indicator if one is hoping for subdued inflation.
So will inflation skyrocket? It does seem that there are several deflationary trends in economies, including the U.S. economy, right now. Technology, labour offshoring, aging demographics, and other trends have in recent years acted to bring prices down. This could prevent any large, persistent increase in inflation for a while.
However, there have been increases in inflation in recent months in the U.S., reaching the higher levels of 4.2% in April 2021 and 5% in May 2021, which have beaten expectations. Some will argue these are the result of ‘base effects’, whereby rates of inflation for the latest month are calculated by comparing the same month but in the previous year. April and May of 2021 are each being compared to April and May of 2020, respectively, when inflation was very low amid the first lockdowns. Inflation rates are, perhaps, only high relatively, not absolutely.
As we head further into summer, these base effects should dwindle; inflation started to pick up slightly in July onwards in 2020, so, for example, the inflation rate in 2021 won’t be calculated against such a low inflation rate from last year. More recent levels of inflation were in fact measured at around 5.3% for June 2021 and slightly lower than 5.3% for July 2021, showing a pause in the rising trend in inflation. Perhaps this pause is an indication inflation will not keep rising and rising - although with base effects seemingly dwindled by now it may also indicate inflation is uncomfortably high.
With U.S. fiscal spending still high and the purchase of U.S. government bonds by the Fed ongoing, inflation worries may still be around for a while. Furthermore, with very high government debt levels and a fragile economy, the Fed may struggle to raise interest rates to fight inflation, as this could greatly increase the servicing costs of government debt and dampen economic activity too much, which could both hamper any recovery in the economy. As mentioned earlier though, deflationary trends may help put the brakes on inflation. Perhaps only time will make it clear whether the U.S. faces a new era of high inflation.