Larry Kudlow has declared the deficit hawks (the inflationistas) the losers of the long raging inflation debate (see here for details). After almost 5 years of QE and thousands of pundits shrieking over high inflation the debate appears to have been convincingly won by the inflation doves (those who thought inflation would be low despite QE). But Larry Kudlow asks an important question – why didn’t QE cause high inflation? Let’s take a look.

First of all, I think QE did cause some inflation. Contrary to popular mythology, I don’t say QE does nothing. It’s more that I just think it’s inadequate. And when we analyze the current environment and impact of QE we have to consider the counter-factual world without having had any QE. If the Fed hadn’t stepped in in 2008 to bolster the banking system we likely would have had a depression in the USA. The payments system would have seized up for months and maybe even all of 2009 and thousands of businesses would have gone under as bank defaults rippled through the economy. This would have been hugely deflationary.

When the Fed stepped in to make a market in MBS in 2009 they were basically creating capital gains to the tune of billions of dollars for the banking system by announcing that all the GSE assets were worth 100 cents on the dollar. And this was in addition to their lending facilities and the other bailout programs. So QE1 had a big impact on the economy in 2009 and 2010.

But what about QE2 and the subsequent programs? Why haven’t they kept the inflation train going up and up? Here, I think it’s incredibly important to separate monetary policy from fiscal policy. The tendency is for people to look at the Fed’s purchases of bonds as financing the deficit. I think that skews the reality and implies that the Fed is needed to buy the bonds (as if there would be no other buyers without QE). We know this is right because QE2 already proved it in real-time when big bond investors like Bill Gross said “who will buy the bonds” when QE2 ended and people like me said “you will buy them!” The “monetization” crowd was wrong as yields tanked after QE2. There was no shortage of buyers for Treasury bonds at all. So let’s just look at QE for what it is – open market operations and not necessarily a part of fiscal policy.

Now, I don’t think it should be controversial to say that spending is a function of income relative to desired saving. Inflation is an extension of spending. And if producers have pricing power due to high aggregate demand or aggregate supply shortages then prices will generally rise (I’m oversimplifying, but for the purposes of this discussion that’s sufficient). So you generally need the spending if you’re ever going to have the inflation. It’s that old demand thing. If you’ve ever run a business you know that revenues and pricing power don’t exist without customers walking in the door.

The problem with QE is that it doesn’t have a transmission mechanism to substantially increase aggregate demand. When the Fed buys bonds from a bank they simply swap reserves for t-bonds. The bank has the same net worth (roughly, depending on any capital gains and as mentioned previously QE1, 2 and 3 have had diminishing returns here) and the reserves sit in the interbank market (and no, they don’t get “lent out”, that’s not how banking works). The bank might feel inclined to shift its portfolio holdings and replace lost T-bond income so it might go buy stocks or bonds of other types, but this doesn’t guarantee sustainable capital gains because there has been nothing directly attached to this balance sheet change that necessarily justifies an increase in share prices.

When QE is done via a non-bank the non-bank gets deposits, sells the t-bond to the bank and the bank does their reserve for t-bond swap with the Fed. Again, there’s no change in private sector net worth and no change in incomes. So, if we go back to our original understanding of inflation (that spending and ultimately inflation, is a function of incomes relative to desired saving) then it becomes rather obvious why QE hasn’t caused high inflation. It hasn’t increased incomes. And it hasn’t increased savings (except maybe for wealthy Americans who own stocks and bonds).

So, what it all really comes down to is this:

1) How much does QE impact rates which can influence lending and investment? I’d argue not that given that QE should have bolstered inflation, but it has actually fallen which has resulted in bond markets bidding prices higher (and yields lower). 2) How impactful is the “wealth effect” and portfolio rebalancing effect? This is the meat of QE. It has powerful psychological effects, but I think the evidence of sustainable capital gains from QE is weak. For instance, why hasn’t QE in Europe supported the peripheral stock markets? 3) How much does QE help shore up bank balance sheets? QE1 probably helped a lot. The subsequent programs probably haven’t helped nearly as much. 4) How much more does the private sector spend when they swap t-bonds for cash? If the wealth effect is substantial then those in the upper class probably spend a good deal more as the value of their cash and bonds increase. Whether this can be sustained or helps the broad economy is up for debate still. 5) Does QE drive down the dollar relative to other currencies leading to more competitive trade? The USD basket is essentially flat since QE started in 2008 so the answer is definitely no.

That’s all a bit oversimplified and it’s not my intention to try to prove that QE does nothing, but if you understood all of this 5 years ago you steered well clear of any hyperinflation or even high inflation predictions. In other words, it looks like QE isn’t everything it’s trumped up to be….

See my QE primer here for a more details look at this explanation.