Free Markets, Free People

L. Randall Wray

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.