Wednesday, December 17, 2008

Quantitative Easing Policy in US

The US have cut interest rates from 1% to between 0 and 0.25%. This is the lowest rate for interest rates in the US. However, there was greater interest in the Fed's plan of quantitative easing - buying assets such as Treasury bonds and mortgage backed securities to effectively increase the money supply.

Many feel that the interest rate cut will do little to boost spending, borrowing and investment. (rates on short term treasury bills are 0% already) However, the willingness to increase the money supply through quantitative easing has been heralded by some as a bold move to deal with the threat of deflation.

As mentioned, the US has already been increasing the monetary base this year. With the velocity of circulation falling, this has not increased inflation (see: Money supply and inflation in US). In fact consumer prices fell last two months.

Quantitative easing is modern day version of printing money. What the Fed will do is buy Treasury bonds and mortgage backed securities, this effectively increases the money supply and keeps interest rates on bonds low.

Quantitative Easing and the Risk of Hyperinflation.

Some economists, argue that a dramatic increase in the money supply that the Fed is proposing could easily lead to inflation and possibly hyperinflation.

At the moment, the increased money supply is not causing inflation because the velocity of circulation is falling. However, if there was a sudden rise in the velocity of circulation, then combined with increase in monetary base, we would see rapid inflation - easily leading to hyperinflation.

Could this happen?

Bond Bubble?

At the moment, there is great appetite for buying US treasury bonds - even though interest rates are close to 0%. However, if investors felt that bonds were not as secure as they hoped, then people would rush to sell their bonds and buy other assets such as commodities this would cause a rise in the money supply and devaluation in the dollar. The risk comes from the rising level of US government debt. If the US lose its credit worthiness, people would no longer want to hold US securities at 0% interest rates. They would sell causing depreciation in dollar and increase money supply. (see: Bond bubble?)

At the moment, the risk of deflation is greater than inflation. Increasing the money supply, is less painful than further government borrowing. But, the Fed will be walking a tightrope - print too little money, the US could be sucked into a deflationary trap; print too much and it could cause inflation.

However, I agree with Greg Mankiw, that a moderate rate of inflation would be a good move for the US economy in its present state

1 comment:

Ralph Musgrave said...

The above is a reasonable explanation of quantitative easing. But I have a few quibbles.
You say “Quantitative easing is modern day version of printing money”. This is not necessarily true, because if a government finances its purchases of securities by borrowing in the market, it withdraws as much money from the market as is injected. And the phrase “quantitative easing” is being used to describe this policy. This is what the Bank of England is proposing to do in the next month or two. I am baffled as to why this should have much effect on demand or confidence or anything else.

A potentially more inflationary version of Q.E. consists of governments purchasing securities with money that is genuinely new money, i.e. printed money. The Bank of England has said it may consider this in a month or two. But even here, the inflationary effects I suspect are minimal. This is for the simple reason that securities are regarded by their owners as savings, and the owners of such savings will not go on a spending spree just because their savings are converted to cash.

The third and potentially most inflationary policy is plain straightforward money printing with no Q.E.: i.e. having government spend more than it collects from tax or borrowing. Even if this doubled the monetary base, the effect could be minimal. This is because commercial banks create about twenty times more money than central banks. The UK monetary base expanded by a factor of 2.6 in real terms between 1982 and 1998: way beyond the expansion of the economy in real terms. Yet this had little inflationary effect.