How Money Printing Works

How Money Printing Works 

A Review & an Outlook

This Wednesday the last FOMC-meeting of this year took place. Although the press conference with Fed-Chair Jerome Powell was less dovish than expected, he assured the public that the Fed will not raise interest rates before 2023. An end of the Feds asset purchases is not in sight because - according to Powell - inflation needs to be sustainable at 2 % for a period of time. The anticipated consequences are highly discussed in the financial world. While one camp argues that low interest rates and asset purchases by central banks will finally result in an inflationary period, the other points out that a deflationary period is more likely. "There have been warnings about inflation since 2008, but it never happened. On the contrary, we saw a period of deflation despite all those central banks actions" - Here, I analyze the effects of different kinds of QE and to argue why until now all this did not result in an inflationary period. Further I want to give you my guess what may happen in the future....

Since the Federal Reserve implemented QE1 and followed the Bank of Japan on its path, economists all around the world have warned about potential inflationary pressures on the one hand and on the other hand that the Fed will put its independence at risk by doing so. They fear that the Fed will never be able to shrink its balance sheet to its pre-crisis size. With the warnings raised every single time a purchase program by the Fed was introduced, Fed officials downplayed the challenge as documented here:

The following chart displays the path of the Fed's balance sheet. To refer to Janet Yellen: the picture is already soaked in paint.

Only under Jerome Powell the Fed has been able to shrink its balance sheet just a little although this try resulted in the repo market crisis in fall of 2019 after QE did replace the Fed's participation in the repo market. Because interest rates have been slashed to zero already and the Fed rejected the idea of negative rates (and still do). Therfore QE had to be implement by the central banks to have some more options to "stimulate the economy".

However the warnings concerning inflation have been complete bogus, inflation is falling steadily since 2008 as the US-CPI 5 year moving average shows. Although CPI numbers ticked up a little bit they're still way below the Fed's average inflation target of 2 %. 

So why there was no inflation? I think it's important to analyze this to be able to make some guesses about future inflation developments. Especially Keynesian and Modern Monetary Theory proponents have argued recently that the last several years clearly show that low-interest rate policies and QE does not cause inflation.

And they're right about the argument (partly) that there hasn't been any inflation despite money supply did rise exponentially. Why? In order to solve this question we have to observe how different sorts of QE affect the economy and inflation.

To be clear: Central Banks in our current monetary system only influence the broader money supply by setting interest rates. It's commercial banks which are the driving force of getting the money out into the economy. Every loan a commercial bank makes causes a liability to the borrower on the one side and creates additional bank reserves on the asset side. Commercial banks expand their balance sheets by lending money to actors in the real economy and as a result, money supply goes up. If the money is used productively and the quantity produced of goods/services goes up as well, one can expect that the overall price level remains more-or-less stable. 

The Fed started QE in 2008 to support the banks because they suffered either from bad loans or from devaluation of - allegedly save - mortgage backed securities. The contraction of the money supply lead to price-deflation in the affected markets and banks faced a liquidity squeeze. 

Here the central banks stepped in and simply bought the toxic assets from the commercial banks, enlarging their balance sheets. New liquidity replaces the MBS on the asset side of the commercial banks balance sheet. This is more-or-less the mechanism that the "inventor" of QE - German economist Richard Werner - proposed to make the commercial banks solvent again. Does this cause inflation? I'd argue it does not. The quantity of money in the real economy is not affected by that and theoretically the central bank could buy all the assets and expand its balance sheet on a huge scale and it still would not have an effect on inflation. 

If the central bank buys an asset from a firm, the asset is now on the asset-side of the central banks balance sheet while newly created money replaces the asset on the firms asset side. The corporation trades assets against bank liabilities. The commercial banks balance sheets expands by additional reserves on the asset-side and a liability on the liabilities side. Within this scenario there is the possibility that this leads to inflation because the quantity of money goes up. 

Central banks have used more-or-less those instruments (apart from negative rates in several countries) before the corona-pandemic crushed the economy in 2020. But the money mostly stayed within the financial markets and therefore only led to a huge pick up in asset-prices while consumer goods basically remained unaffected. 

Another aspect is the velocity of money: Milton Friedman expected that the velocity of money remains constant. According to this assumption an expansion of the money supply should have resulted in inflationary pressures - but it has not. 

With reference to the US I think that there are several reasons for that: The US has a huge trade-deficits which means that they exchange dollars for goods. As a result those dollars flow out of the country and those dollars do not impact the measurement of inflation (exporting inflation). 

Further the US-dollar is still the world's reserve currency; the major commodity trading is done in US-dollar. Commodity prices have fallen since 2008 - as the Bloomberg Commodity Index shows although it may break out of its downtrend soon.

As mentioned above lots of the printed money was invested into asset-markets which are not measured by inflation. Further many companies hold back on investment and also banks did so on loans.

In short this means that for every new created unit of currency, growth lacked behind. Look at the following chart: It shows the US 5 year average of Nominal GDP growth YoY - Money Supply Growth YoY (white line) and US money velocity (blue line). As you can see the newly created currency unit failed to spur growth. The more money was pumped into the economy the less growth was the result. That's why I think that governments will fail if the think that growth returns if they ramp up spending.

In the current crisis expanded their budgets: In the United States the government introduced unemployment benefits to cover their life expenditures. The extra benefits where so high partly that some unemployed got paid more money for being unemployed as they got paid in their jobs. To run deficits, governments issue bonds. 

If the government sells bond to an individual/company the governments account at the central bank goes up the same amount the individuals/firms bank account goes down. The individual/firm has a treasury bond on its asset side. The central bank has a liability to the government. 

Then the government spends the money, let's say the want to raise unemployment benefits. At the central banks balance sheet the money moves from the government to the commercial bank account. Combined the balance sheets of all individuals has lengthened by one treasury note but the money supply in the real economy did not change. Therefore no additional money was printed and hence it should not lead to inflation. 

If a commercial bank buys the treasury instead of an individual/firm the treasury lands there's a transfer of money on the central banks balance sheet from the commercial bank account to the governments account. So no balance sheet expansion at the central bank. 

However, the balance sheet of the commercial banks expands: Firstly, a treasury bond lands on the commercial banks' asset side. As soon as the government spends the money to the beneficiaries, their account (a commercial bank's liability) goes up which creates an additional bank reserve on the commercial bank's asset side. The quantity of money went up, trading for the same amount of goods in the economy as before and therefore this process is inflationary. Government debt also went up. 

The current environment of zero percent interest rates had another consequence: It encouraged government/businesses/individuals to borrow more money. Rising prices in the areas where the money is spent are guaranteed: If it lands in the real economy with low growth, prices rise there.If the new money chases assets like stocks, bonds or housing, prices will go up there.

Governments have a bad habit of replacing old debt with new debt. In recent times there have been enough buyers who did absorb this issuances. However, a situation may emerge (bad growth expectations for example) where individuals/banks/businesses may cut back on their bond buyings and instead buy other assets like gold, silver or even cryptos for example. To keep bond yields at current rates the central bank has to step in and now buying bonds directly from the treasury department. This is what is called debt monetization. 

As a result the central banks balance sheet would expand by the amount of treasuries they buy on its asset side and by a liability to the government. If the government spends the money to beneficiaries the balance sheet of the commercial banks expands as well, creating an additional bank reserve on the asset side and a liability to the beneficiary on the liabilities side. If this situation emerges - be prepared that governments will be ready to use it big time. "Imagine all the green projects we could invest in" they will say. This would be a game changer and send inflation upwards as the money flows directly into the real economy and tie up resources for those projects. However, currently this is not happening as central banks only buy bonds on the secondary market where already issued bonds are traded. 

Lots of buyers of treasury bonds are foreign investors and hence risks spread all around the globe. Interestingly it seems that foreigners cut back on their treasury buyings recently as the following chart shows.

Maybe the Fed will have to step in sooner than one expects: In the last days of 2020 treasuries worth 1 trillion US-dollar will expire, following by enormous 5.8 trillion in 2021. Currently the Fed buys treasuries at a pace of 80 billion a month which won't be enough to absorb such a huge amount.

This is not just an American problem: UniCredit projects that the ECB will buy more bonds and bills from the euro-area member states than those will issue in 2021:

One can expect that we will not overcome the corona-pandemic totally in 2021 (Bill Gates already said in an interview with CNN that 'normality' will not start before 2022) and therefore one can expected that deficits will explode further as no government anywhere in the world has a sustainable strategy to combat the virus without lockdowns. 

This may be the catalyst for debt-monetization to keep interest rates at current levels. Otherwise they would pick up substantially. On Wednesday at the FOMC-press conference Powell stated that the Fed will stay at the side line and watch inflation going up until full-employment is restored. I doubt that this strategy will hold. 

I've shown that QE in this crisis highly differs from QE of the GFC: Back then central banks have rescued banks an bought their non-performing assets. Later they also started to buy treasury bonds (some also corporate bonds) to keep interest rates from rising. This created a bond bubble that is now replaced with an everything bubble. QE hasn't been very inflationary until now but in this crises the bazooka will be fired. 

Have a great weekend! 

Fabian Wintersberger 

Disclaimer: This is a personal blog. Any views or opinions represented in this blog are personal and belong solely to the blog owner and do not represent those of people, institutions or organizations that the owner may or may not be associated with in professional or personal capacity.


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