By David Moon
When the Federal Reserve began a three-stage quantitative easing program that would eventually create $3 trillion out of thin air, there was much disagreement about the advisability and risks of the plan. There was one topic, however, in which there was little disagreement: that “printing” that much money would lead to increased inflation.
The consensus expectation was reasoned, conservative, based in history—and massively wrong. An explanation requires some background.
Quantitative easing grew out of the October 2008 $475 billion Troubled Asset Relief Program (TARP.) TARP was an emergency plan to provide badly needed liquidity in a money market system that was on the brink of paralysis. The program worked and 6 weeks following the $475 billion liquidity injection the credit markets returned to a semblance of relative normality.
If a few billion dollars was good for the economy, then a few trillion must be great.
Thus was the genesis of the eventual $3 trillion of newly created money. The Fed creates money by purchasing bonds in the open market. When the Fed buys a bond, it doesn’t send the seller cash (or an equivalent asset from its balance sheet.) It simply makes an accounting entry on the books of the selling bank, crediting their account for the purchase price.
But the Federal Reserve has no money or asset to transfer to the selling bank.
When banks receive this newly created money, it increases their ability to make loans, typically by a factor of 8 to 9 times. As banks lend this previously unavailable capital, it increases construction, equipment purchases, new business creation and all sorts of economic activity, leading eventually to increased inflation.
That’s the theory, anyway.
Since 2007, the annualized inflation rate in the U.S. has fallen from 4.1 percent to a reported 0.7 percent in 2015, despite all that newly created lending capacity.
What too few people considered in 2008 was that that $3 trillion in new dollars would not create inflation if it never made it into the economy.
Of that $3 trillion, more than $2.5 trillion is still sitting on bank balance sheets as excess reserves. To place that into perspective, from 1985 to 2008, the U.S. banking system operated with almost no net excess reserves.
It is, of course, tempting to criticize banks for not increasing their lending. That logic is faulty, however, since banks are profit-seeking entities that could make a lot more money loaning money at 6 percent rather than earning the 0.25 percent the Fed pays on excess reserves.
There simply isn’t sufficient demand for creditworthy loans.
Interest rates will increase when inflation expectations increase—which won’t happen until the economy strengthens enough to support more bank lending. Until then, that $3 trillion will remain as excess reserves, creating neither economic activity, inflation nor higher interest rates.
David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).