All of the buzzwords in one post: quantitative easing, inflation and printing money

Sunday, November 30, 2008

I have received many emails from readers that are concerned about current Fed policy. In this post, I will address the following issues: what is quantitative easing; is the Fed printing money; and finally, will the Fed’s massive liquidity injections lead to inflation.

Quantitative easing (QE) by the Fed has begun. But before we can address the Fed’s QE strategy, we must get one thing straight. First, a QE policy is not a zero interest rate policy (ZIRP). The federal funds target is currently 1%, and although the Fed has initiated a QE strategy, it has not declared ZIRP…yet. The next scheduled meeting is December 15-16, where the Fed may very well set the policy rate closer to 0%.

Without explicitly setting the federal funds target to 0%, the Fed is currently engaging in another non-traditional policy, quantitative easing (QE). Under a QE policy, the Fed increases bank reserves beyond levels consistent with ZIRP (technical definition according to Bernanke, Reinhart, and Sack). QE implies that the Fed no longer targets an interest rate.

The flood gates are open. The Fed is injecting the banking system with shiny new reserves (liquidity) and is no longer using open market operations to keep the effective federal funds rate – the overnight interbank loan rate – close to its target, currently 1%.

In laymen’s terms, the Fed is printing money under the QE policy; the idea of the Fed printing money has clearly caused some confusion for readers. Printing money is a pejorative term that is often associated with inflation, or worse, hyperinflation. In normal times, a QE strategy would certainly result in newly available money, but we are not in normal times.

The Fed is not printing money, rather it is printing high powered money, where high powered money is the monetary base (reserves).

What is the difference between money and high powered money? Money is a function of two things
  1. The monetary base, which equals bank reserves plus currency in circulation
  2. The money multiplier, or how quickly the base switches hands in a fractional reserve banking system (for a discussion of money creation, see this wiki article).

The Fed is raising the monetary base through its QE policy and increasing its balance sheet (credit extended to the banking system) from $884 billion on August 28 to $2.1 trillion on November 28. The Fed simply creates new monetary base (reserves) out of thin air; hence, the printing money connotation.

However, banks are hoarding the new base in the form of excess reserves, and lending has slowed significantly relative to the size of the new reserve base. Therefore, the money multiplier is collapsing.
Will the Fed’s QE strategy lead to inflation? In the short-term, no. The money multiplier is falling because the economy is in a nasty recession alongside a serious credit crisis. In this environment, the surge of high powered money will not cause prices to rise.

Prices can drop in a recession (deflation) because the demand for goods and services falls with rising unemployment and declining income. But the 2008 recession is accompanied (or partially caused) by a credit crisis that induces banks to hoard the new base as excess reserves; this adds to the deflationary pressures (possibly reducing the money supply). If deflation were to become embedded into consumer and firm expectations, then the macroeconomy could be facing a severe problem. So for now, and until the economy emerges from its recession, QE will not lead to inflation.

But what happens when the economy rebounds? Inflation becomes a serious risk if the Fed does not extract the high powered money. If the Fed gets it wrong, or its timing is off, then the money supply will rise quickly as banks start to lend more freely, and inflation results.

In the US’ case, I see the Fed getting it wrong as a serious risk to price stability (rising inflation). American consumers are not savers and love to spend; and although some suggest that the American saving behavior has changed, the evidence is far from concrete. Unless saving rises permanently - the economy transitions to a world where consumption is less than 70% of GDP - consumers will be more than happy to swoop up the new bank lending and spend that new easy money.

Rebecca Wilder


OKL November 30, 2008 at 8:20 AM  

i don't quite get it; how does the fed just 'extract the high powered money'?

and when this is done, what does it do to the banks that were being injected?

thanks for the great post; new to this website and still surfing around.

Anonymous November 30, 2008 at 11:15 AM  

Wouldn't a drop in demand for money cause a spike in prices?

Janie November 30, 2008 at 12:21 PM  

Since one of the Fed chiefs (NY) is leaving for Washington, couldn't the appointment of a new one lead to a slightly different "Fed" and, therefore, their reaction to the situation? You are right - we are not savers and I just don't think in the long run the increase in savings will last. There might be some hope in the teenagers and 20 somethings learning from our present problems. Thanks for this explanatory post - we non-economists need it. aj

JKA on Economics UK November 30, 2008 at 2:06 PM  

QED The Fed has provided so many loans and emergency funds,capital injections and credits to banks, brokers, money funds, insurance companies, (car dealers), the balance sheet is as leveraged as that of any hedge fund. Consolidated assets amount to 53 times capital. The Fed’s current capital ratio is 1.9%. If the Federal Reserve were a commercial lender, it would be a candidate for a government bailout.
Will the Fed be able to mop up the excess liquidity assuming an upturn. ZIRP's and TARP's aside?

fractionaltime November 30, 2008 at 6:48 PM  

a really important terminology has been ommitted from this article and that one is at the core of the article which is like a key......
The concept of a "fractional reserve banking system" or just plain "fractional reserve" which is part of the very real functioning of the banking system and its relation to the fed.
This is just my view and explains levaraging better than the terminology off levaraging from the little i know....
I found youtube "Banking Blow" (10mins)and "Money as Debt" 4 invaluable to understanding money as it exists today and how it is created out of thin air or printed by any other name..

fractionaltime November 30, 2008 at 6:58 PM  

With respect, the wiki link explains fractional reserve....i think the article is the best i have read...great article thanks kindly. I am very new to all these concepts and "fractional reserve" blew my mind when i first understood it.

Rebecca Wilder November 30, 2008 at 8:50 PM  


You said, “i don't quite get it; how does the fed just 'extract the high powered money'?”

Traditionally, the Fed does through restrictive open market operations – selling Treasuries in exchange for bank reserves. However, the Fed has added liquidity through various lending programs – TAF, PDCF, TSLF, discount window, CPFF (you can see the various facility descriptions here So it can simply let the programs come to term without offering new loans, raise the discount rate or not roll over commercial paper funding. However, each of these funding programs are backed by collateral (various types of debt instruments), and so the Fed can only unwind once the credit markets have improved.


Hi anonymous,

You said, “Wouldn't a drop in demand for money cause a spike in prices?”

Yes, given that the money supply stays the same, but if the money supply falls enough, then prices would fall. It should read that slackening demand causes prices to fall, which reduces the quantity demanded for money.

Thanks, Rebecca


You said, “Will the Fed be able to mop up the excess liquidity assuming an upturn.”

One can only hope. Time will tell, but the Fed’s timing and exit strategy will be of upmost importance!


jp December 1, 2008 at 1:26 AM  

Great post. Sheds more light on my desire to understand money and banking, which was brought about by our current credit crunch.

Flow5 December 1, 2008 at 6:08 PM  

Prior to Oct 6, 2008, virtually all Fed power over interest rates was exerted though its “open market power”. The “trading desk” at the Federal Reserve Bank of New York, bought & sold securities for the accounts of the 12 Federal Reserve District Banks.

However, the Board of Governors of the Federal Reserve System announced that beginning on Oct 9, 2008, it will pay interest on bank excess, and required, reserve balances.

With interest-bearing-reserve-balances (IBRBs), federal funds rates are set (separately) by the rate paid to the commercial banks, on their (1) excess and (2) required reserve balances. And when IBRBs are created, these excess reserves are substitutes for, open market operations.

The growth in the quantity of IBRBs is therefore, an independent variable, and doesn’t influence whether depository institutions are capable of creating new money & credit.

Therefore the Board of Governors compilations for total reserves, and excess reserves (which includes applied vault cash), held by the member commercial banks in their District Reserve Banks, no longer “supports” a given volume of money. The “money multiplier” no longer exists.

Alex December 1, 2008 at 9:51 PM  
This comment has been removed by the author.
Roo Ball December 1, 2008 at 9:53 PM  

I would make one addition to Rebecca's answer to the following:

"i don't quite get it; how does the fed just 'extract the high powered money'? "

Another method could be for the Fed to raise reserve requirements and to impose higher penalties (not just fines but sanctions) for violating them. Maybe even make banks pay to hold reserves at the Fed. :)

Rebecca in CO December 5, 2008 at 4:02 PM  


Sorry, my comment should have gone here:

I'm greatly enjoying your posts and wanted to let you know I linked to this one for my Money and Banking class. Quick question on the figures - you state that the monetary base on Nov 28 was 2.1 trillion. But isn't this the whole set of liabilities, not just currency plus reserves? Or does the definition of monetary base need to be expanded to include these other liabilities? If you just take currency and reserves, the monetary base for Nov 28 was more like 1.5 trillion, which means the multiplier hasn't fallen quite as much as you calculate.

Keep up the great posts.
-Rebecca in Colorado

Rebecca Wilder December 5, 2008 at 4:32 PM  

Hi Rebecca,

Thank you for the compliment!

I assume that you are talking about this paragraph: “The Fed is raising the monetary base through its QE policy and increasing its balance sheet (credit extended to the banking system) from $884 billion on August 28 to $2.1 trillion on November 28.”

I am sorry if that is slightly unclear. The Fed balance sheet increased TO $2.1 trillion in 3 months. That is an additional $1.3 trillion on the balance sheet. Part of that was raised via the TSP account, around $600 billion, but the rest was mostly reserve creation. So yes, it is the whole set of assets, not just the base.

Who is your money and banking Professor? I got my Ph.D. from CU!


rap star May 24, 2009 at 11:27 AM  

thank you!

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