Why QE2 WIll Cause Inflation

Keynesian Failure blog:

Now that the Fed has said it’s “prepared to provide additional accommodation if needed”, all that remains to be seen is how much worse things have to get to reach the Fed’s “if needed” threshold, and just how many units of “accommodation” the Fed is “prepared to provide”.
Everybody knows that “accommodation” means quantitative easing. But my readings of professional analysis, media articles and online forums have made clear to me that QE is still a very poorly understood topic. Most people are assuming that this coming round of quantitative easing, or QE2, will have more or less the same result as the last episode in 2008-2010. That is, not much result at all.
But QE2 will be very different from QE1, because it will be conducted differently in very different conditions. Here are three crucial differences between QE1 and QE2 that explain why I think QE2 will be significantly more inflationary than QE1.
QE2 will take place amid less financial stress. The bulk of QE1 coincided with a severe financial implosion. By contrast, QE2 will be launched during a period of protracted stagnation. Houses and the financial assets backed by them will again be falling in price, but their second leg down will not be as sharp or as widely unforeseen as the first. The economy will most likely be contracting before QE2 is launched, but probably only mildly, at least initially.
QE2 will displace traditional buyers of Treasuries into other dollar assets. In QE1, the Fed bought mortgage bonds at a time when foreigners desperately wanted out of the American mortgage debt market. Many of these foreigners switched to cash dollars, which can be seen in part in the sharp increase in cash assets of US branches of foreign banks. In QE2, the Fed will be buying Treasuries at a time of high domestic and foreign demand for them. QE2 will likely amount to about $80 billion per month of Fed Treasuries purchases, up from the roughly $20 billion per month that the Fed is currently buying to replace its retired mortgage debts. That’s out of about $120 billion per month of net Treasuries issuance.
That means about $60 billion per month of private and foreign buying of Treasuries would be displaced into other assets. If those displaced, would-have-been-buyers of Treasuries switch to some other kind of financial assets besides cash, they will displace yet others from other financial asset markets, and so on and so on. If there is not enough demand among the private sector and foreigners to increase the overall pace at which they are accumulating cash dollars, the market will instead satisfy those displaced would-have-been-buyers of Treasuries by creating new financial assets through a credit expansion.
QE2 will not meet any pressing demand for cash. QE1 satisfied a panicked scramble for scarce cash in over-leveraged private markets as credit markets broke down. In QE2, the Fed will be pushing dollars into an economy that is stagnating because the private sector doesn’t want to invest the large amounts of cash it already has. This implies that the private and foreign net buyers of Treasuries who will be displaced from the Treasuries market by QE2 will probably not be nearly as eager to switch to cash as were the sellers of mortgage debt during QE1.
About 90% of QE1 met heightened demand for cash, and only about 10% fueled credit expansion. It’s difficult to predict exactly how markets will accommodate QE2, but I think it’s safe to guess that the portion that fuels credit expansion will be at least 25%.
That might seem like no big deal, a mere $15 billion per month. But thanks to fractional reserve banking, the increase in M2 would be somewhere in the range of $90 billion to $120 billion per month. By comparison, M2 has increased by an average of less than $40 billion per month since QE1’s launch two years ago.
That is why I am expecting a significant acceleration of inflation from QE2, in contrast to the very low pace of inflation that has followed QE1. It is possible the Fed could mitigate this inflation, either by reducing or discontinuing QE, or by raising the rate of interest paid on reserves to encourage more accumulation of cash. But as we all know, the Fed is consistently late to change courses. Almost inevitably, inflation and interest rates on almost everything except Treasuries will be going significantly up.
And that will be devastating for the housing and financial sectors. They are being kept on the artificial life support of near-zero interest rates, instead of letting the market find a true bottom, writing off losses, recapitalizing and moving on. Unfortunately, delaying the day of reckoning is only moving that bottom lower.