Inflation debt and printing money all have one thread connecting them together which is interest rates.
Interest rates are the lubricant of the monetary system. In normal times Central Banks raise or lower rates in an attempt to keep business running smoothly. Since 2008 Central Banks have added a new tool to mange the economy – Quantitative Easing and Quantitative Tightening.
Does Quantitative Easing (QE) cause inflation?
Absolutely not.
Here’s why…..
There are two types of money: real economy money and financial sector money.
Simply put, real economy money is used everyday by household and corporations to conduct business. Financial sector money is used by Central Banks, commercial banks, pensions and asset managers mostly as interbank financial plumbing operations.
The big difference is financial sector money is never used in the real economy, its sits on bank balance sheets as reserves. Banks keeps reserves to ensure enough dough is on hand to meet depositor withdrawals and prevent bank runs. However, banks don’t sit on reserves they invest reserves to earn a higher returns thereby diving asset prices higher.
Credit/Money Creation
Understanding how credit or money is created helps decipher why inflation is a problem in 2022.
When governments ran deficits to bailout the economy during the pandemic they created real economy money and spent it immediately. In addition, Central Banks fired up Quantitative Easing to beef up the reserves on bank balance sheets to ensure no repeat of the 2008 credit freeze.
Both responses to the pandemic created massive amounts of real economy money and financial sector money. The result was a massive growth in GDP (real money growth) and in asset prices (roaring stock market) across the board.
Final thoughts
In the end, does Quantitative Easing (QE) cause inflation? The answer is no.
The creation of real economy money by means of government deficit spending leads to GDP growth and inflation. While Quantitative Easing boosts asset prices for stocks and bonds.
Today we are experiencing the opposite of the response to the pandemic. Higher interest rates and less government spending reduces real economy money. Credit creation slows as Banks are cautious about lending and the economy slows. On the other hand, Quantitative Tightening reduces bank reserves and the desire to bid up asset prices fades along with prices. Sound familiar.
From a long-term perspective understanding credit creation and what causes inflation can be a big help when determining asset allocations. For now, until credit creation picks up the economy is likely to slow further, just as the Federal Reserve wants.
Thanks for reading!
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