Free Markets, Free People

QE2 is unlikely to save the day

In fact, it may set in motion inflationary pressures that will blow up in the Fed’s face.

Randall Wray has put together one of the best summaries I’ve seen on the subject, and it doesn’t give me a warm fuzzy at all.  Essentially QE2 (“quantitative easing”) has the Fed buying up toxic bank assets to push up their excess reserves.  The thinking is that pushing those reserves into excess will stimulate loans.  But it will also stimulate inflation. 

Bernake’s claim is the reserve creation will be “temporary”.  But – and this is the crux of the problem – it will have difficulty buying back those reserves because of the quality of the assets the Fed is sucking up to create them:

Bernanke carefully tries to navigate these waters by agreeing with the hawks that in the long run, Fed creation of too many reserves would be inflationary, but argues that in current circumstances the greater danger is deflation. Still, he reassures markets that reserves creation is temporary, and that the Fed will “exit its accommodative policies at the appropriate time”. Yet, if the Fed buys junk assets that will never have any value, it will not be able to sell these back to markets later — so there is no way to remove the reserves it created when it buys trash.

Indeed.  So without the ability to sell back marketable assets, the reserves remain out there and inflation does too.  You might think “deflation” is the biggest threat until you see run-away inflation reduce your retirement funds to zip and push your wages to poverty level.

This is a mess.  And as we discussed in this week’s podcast, screwing with the economy at the central bank level is very delicate thing and could go wrong quickly and dramatically. 

And what I’m hearing and reading – to include this article – says the possibility of that happening is high.



8 Responses to QE2 is unlikely to save the day

  • Actually, many of the assets the Fed is allegedly going to buy are none other than US Treasuries that have been sold to ‘too big to fail’.  This is debt monetization with a middle man.
    Another thing to worry about is if inflation does get going the Fed’s number one tool for slowing that is to raise interest rates.  One can only imagine the pressure that will come out of DC to not take that path while the congress critters are running trillion dollar deficits.
    One last thing.  Can anyone show me a historical example of debt monetization that worked out well in the end?

    • Maybe when he said “toxic bank assets” the  US Treasury bonds were included? 🙂

      • That may very well be the result.  US Treasury bonds become worthless. 
        Then what will the government do?

  • It seems to me that the idea is to try and see how far you can crawl out on a limb before it breaks, hoping that the economy recovers in time to save you.  Isn’t that one of the main factors that made the recent economic crash so bad?  After government officials excoriated Wall Street for taking such large and foolish risks, it goes ahead and does the same.

  • I too am worried about inflation, but…our understanding of monetary policy has moved beyond the old monetarist/keynesian argument. Check out Scott Sumner’s blog, to see how we can help put the economy back on track without losing control of inflation.

  • I don’t see how deflation is so bad right now. Why are these high-up people trying to prevent it, when we’ve been inflating for decades? Now, if we had deflation while the rest of the world was having inflation problems, and we were an exporting country, I would see how that could be somewhat undesirable (see Japan right now), but that’s about the opposite of what’s happening in the US.

    But I’m no economist, so what do I know?

  • Wish I could have bought a little more gold when it was cheap. I am now buying silver.

  • And as we discussed in this week’s podcast, screwing with the economy at the central bank level is very delicate thing and could go wrong quickly and dramatically.
    Haven’t these guys done enough screwing around already?