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QE is not Inflationary, Thoughts on Risk Asset Instability

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January 29, 2011 – Comments (32)

"QE is not inflationary". What are you smoking binv? Everything in the US from stocks, to oil, to junk bonds, to toilet paper is going up, so that must mean Quantitative Easing is inflationary ... right?

No. it's not.

It is not incompatible to have a non-inflationary QE program and a rising stock market (or really a rising set of any number of risk assets). And it is a far more dangerous long term scenario, that will lead to risk asset instability.

But first, let's tackle why QE is not inflationary.

'QE is money printing, which makes it inflationary'. Except that it's not. Quantitative Easing is an asset swap. At the end of the day, it is nothing more fancy than that. The Fed takes reserves and purchases Treasuries. The main goal of QE as stated by the Fed back in Sept/Oct was to lower long term interest rates, which will stimulate borrowing and then eventually stimulate the economy.

That is all that is taking place. This results in both intended and unintended (and I have rethought which was which in the past few months) consequences. But it is not inflationary. And the key to understanding this is to understand the role of the Treasury/Fed interaction. I have gone through this in detail here (The Matter of Deficits, Sovereign Default, and Modern Monetary Theory) and here (The US Treasury and the Federal Reserve: Redundant Institutions). Both of these pieces were influenced heavily by The Pragmatic Capitalist who I believe understands the current reality of Fed / Treasury operations better than anybody.

Here is the highly simplified and shortened version of the two posts above:

Treasuries do not fund anything. Once upon a time (prior to 1971) they did. But they are no longer a fiscal (financing) tool. They are a monetary tool. Treasury issuance is the mechanism by which the Fed maintains its overnight rate. The Fed purchases Treasuries in order to soak up excess reserves. That's it.

Think of it like a savings account vs. a checking account. Cash is an extremely short term asset (which is by definition a government liability) and a Treasury is a longer term asset. They are exactly the same thing other than interest and duration to maturity. The primary distinction being 'liquidity' and interest. So swapping one for the other simply moves money that institutions hold as a 'savings account' (longer dated Treasuries) to money in a 'checking account' (Cash). If you want to explore this in more detail, I would recommend here and here.

At the end of the QE transaction, the same amount of net financial assets is *exactly* the same (see here). Publicly held treasuries are swapped for cash.

This is the critical point that leads to two observations:

1) QE is actually deflationary since it takes an interest bearing asset away from the public and swaps it for cash.
2) There is more cash (a zero-maturity asset) -> There is more liquidity in the system

Now here is where we get to risk assets. The Fed stated that the primary goal of QE-II was to bring down yields on the long end of the curve by buying those Treasuries (thereby increasing demand and driving Treasury prices up). What has happened in reality? The exact opposite. Long Term Treasuries yields have actually been *increasing* since QE-II has transpired.

Strike 1 for Ben, right? Maybe. But just thinking like bond holder for a second, if a large institution (such as the Fed) with a huge amount of reserves was able to soak up a large amount of Treasury selling, then why not sell some now and purchase later? Think of it like this, if all the long term Treasury holders go to sell at the same time, prices will plummet and yields will skyrocket. But if a party steps in and says 'I am buying half a trillion or so of long term Treasuries', then why not sell part of your position and book some profits? If a number of people think think this, and it is larger than what the Fed is purchasing, then prices will drop based on the selling pressure. But it would be less than it would otherwise be since the Fed has announced that it is a large buyer. And since you are a bond investor, and you are smart, and you understand that QE is deflationary (from observation 1 above), then likely you will get a chance to repurchase your Treasuries at a better price sometime in the future.

So with respect to the Fed, having failed at their primary reason for QE-II could be for two reasons: i) They did not understand that this would happen (unlikely) or ii) This was not in fact their primary reason for QE-II.

Which ties into observation 2 above: There is more cash (a zero-maturity asset) -> There is more liquidity in the system

Treasuries prices are falling and there is more liquidity sloshing around in the system. This means that risk assets are going to get a bid, and big time. And that is exactly what happened. There are many who called this, including most notably David Tepper, back in September and it is clear they were right.

A few things had to happen to this to play out. Excess liquidity by itself does not necessarily mean that all risk assets get a bid. But with stocks in particular, all of dominoes did in fact line up:

a) There had to be actual GDP growth occurring (which there has been)
b) Earnings has to be growing (and they have been)
c) Corporate balance sheets had to be improving (and they did)

Those combined with the excess liquidity sparked a supercharged rally. Again, I give nothing but props to those that saw this setup manifest like this.

So, in retrospect, the real reason for QE-II was so that the Fed could add a Third Mandate:

To keep risk asset prices higher than they would otherwise be

So while I think that the next few years will likely see a continuation of this cyclical bull stock market (P/Es are in another expansion cycle right now, and the market is getting a goose from excess liquidity), this gets at the heart of why I think this is unstable over the long term.

I talked about many of these thoughts here: Macro Thoughts and Observations. Is the Bear Market Dead? Is this the Start of a new Secular Bull Market?

For the short term, the psychological impact of QE2 has a huge boost on the stock market. And the FED can pump liquidity (and extra liquidity usually finds its way into risk assets) all it wants. It is, after all, the Central Bank. And over the short term and intermediate term, risk markets respond 'favorably' to this excess liquidity.

But over the long term, as economic fundamentals cannot support the revenue streams to generate the earnings that artificially inflated stock prices expect to keep growing, then we have crashes. The 2000-2002 crash was based on the unsustainable dot-com valuations. The 2007-2009 crash was based on unsustainable consumer spending due to the housing bubble bursting as well as deleveraging of financial assets tied to the housing bubble. The next bubble will form (and pop) due to excess liquidity sloshing around in risk assets that get completely divorced from sustainable fundamental economic drivers.

This makes this wave a bubble in motion, but I don't think it is at it's popping point yet.

Here are John Mauldin's thoughts on the FED's Third Mandate (which I completely agree with): (see: http://www.johnmauldin.com/frontlinethoughts/thinking-the-unthinkable)

The Fed has two mandates: keeping prices stable and creating an economic climate for low unemployment. I am sure I was not the only one to listen to Steve Liesman's interview of Ben Bernanke this week and shake my head at the spin he was giving us. First, let's set the stage.

In a paper with Alan Blinder early last decade, Bernanke made the case for the Fed to target a specific inflation number, and the number that came to be accepted as his target was 2%. In his famous helicopter speech in late 2002, he assured us that inflation could not happen "here," even if the short-term rate was zero, because the Fed would move out the yield curve by buying large amounts of medium-term bonds. This would have the effect of lowering yields all along the upper edge of the curve. This became known as quantitative easing. In Jackson Hole last summer, he made very clear his intention to launch a second round of liquidity-injecting quantitative easing (QE2). In that speech, in later speeches in the fall, and in op-ed pieces he said that such a program would lower rates.

Then a funny thing happened on the way to QE2: long-term rates began to rise all over the developed world. As Yogi Berra noted, "In theory, there is no difference between theory and practice. In practice, there is." It's got to be driving Fed types nuts to see the theory of QE, so lovingly advanced and believed in by so many economists, be relegated to the trash heap, along with so many other economic theories (like that of efficient markets). The market has a way of doing that.

So, Liesman asked Bernanke about one minute into the clip (link below) about the little snafu that, following QE2, both interest rates and commodity prices have risen. How can that be a success? Ben's answer (paraphrased):

"We have seen the stock market go up and the small-cap stock indexes go up even more."

Really? Is it the third mandate of the Fed now to foster a rising stock market? I wonder what the Fed's target for the S&P is for the end of the year? That would be an interesting bit of information. Are we going to target other asset classes?

Understand, I am not against a rising stock market. But that is not the purview of the Fed. And certainly not a reason to add $600 billion to the balance sheet of the Fed when we clearly do not understand the consequences. If it looks like they're making up the rules as they go along, it's because they are.

Here is the clip: http://www.cnbc.com/id/15840232/?video=1742165849&play=1


Excess liquidity is a very powerful blunt instrument. As I pointed out in Moving Some Macroeconomic Deck Chairs: The Dollar, Dollar Swaps, Bonds and LIBOR

First, we have the credit bubble bursting. In 2007, We are coming off a flat, and sometimes even inverted, yield curve in 2005-2006 and the curve begins to steepen. This is a sign of things to come. Financials are in horrible shape. Leveraged to the hilt and untrusting (LIBOR is at >5%), it takes only the exhaustion of bullish euphoria to start the avalanche. Financials lead the slide down, the yield curve continues to steepen, confidence and over-bullishness is replaced by fear.

Next we have the Great Deleveraging Event of 2008. It is clear the game is up and everybody has to liquidate their over-leveraged positions. We see some interesting behavior take place. The Dollar rallies, as people fly into Treasuries as a safe haven move (not unexpected). The Dollar doesn't rally because it is "strong", it rallies because it is "in the way" (by definition, you have to move assets into US Dollars to buy US Treasuries).

But we also have a very steep drop in LIBOR during the deleveraging crisis. Why is that? If everybody, most especially financials are scared, because there is a deleveraging and liquidity crisis, why would LIBOR go down?

Because the Fed was pumping the system with Dollar Swaps!!

**If you want the real reason for the "bottom" in March 2009, there it is.**

All arguments for compelling valuations are BS, or "once in a lifetime buying opportunities" are BS. We stopped the freefall NOT because the market said "no mas", but because the Fed stuck an inflatable pool halfway underneath the cliff divers trajectory. It forced liquidity into the system as it was seizing up. If you really want to understand this issue, read Kristjan Velbri's excellent post Dollar Liquidity Swaps & The Financial Crisis.


The FED is playing a dangerous bubble game here. The term 'papered-over' has become overused. But it is still apt. The idea is that a rising stock market will create a 'wealth effect' and encourage people to spend more and take on more debt to generate economic activity. I think this continues to be a bad assumption. The consumer is deleveraging (and *needs* to). House prices are still depressed. We are still in the midst of a private sector balance sheet recession. The consumer will not lead the way to a major economic upturn. So a rising stock market without fundamental backing is destined to be simply another countertrend rally (just like 2002-2007 was).

But that is for the long term. Intermediate term (the next couple of years), there is no reason why this (unsustainable in the long term it may be) can't be fuel for a continued cyclical bull market rally.

Obviously there are other factors at play, but I would consider this to be a checkmark in the bull's column for now.

The Fed wants a risk asset rally, and it got it. And it wants the cyclical bull market to continue, and I think it will do that too. It's primary goal is to create a 'wealth effect' from a rising stock market. While that might have some short term impact, it has a very dubious long term impact: http://pragcap.com/robert-shiller-debunks-stock-market-wealth-effect.

But keeping asset prices 'higher than they would otherwise be' will create instabilities. Which means before this cyclical bull market is over we will see another very volatile period like 2010.

Make no mistake however, excess liquidity does not equal economic activity. It will amplify stock market signals (rallies) based on economic growth (which there is), but will also amplify downturns when said growth stalls (and it will). Feedback works both ways, as any signals engineer will tell you.

QE, while not inflationary, does create excess liquidity which acts like an amplifier. Which means that there exists the increased potential for instability. And I don't think many people are appreciating that fact.

For some thoughts on how that could manifest, see this: Bear Market Momentum Internals: Examination of Moving Average 'Price Stretching'

32 Comments – Post Your Own

#1) On January 29, 2011 at 2:33 PM, dbjella (< 20) wrote:

This stuff is confusing :)  Bvine I like your detail, but I need help.

Lets say we have 3 parties Suckling Pig, US Gov't and Federal Reserve (Fed).

US Gov't to Suckling Pig: I am going to stimulate and give you $2 billion.

Suckling Pig:  Really?  Where you going to get the money?  Cuz, you have spent all your tax revenues.

US Gov't:  Deficit spending.

Suckling Pig:  Huh? Where are you going to get the money?  Your not going to give me $2billion and then turn around and take it back right away are you?

US Gov't: Nope.  We have our ways (in Col Hochstetter voice). We will issue treasury bonds.

Suckling Pig: I'm not buying those crappy bonds. You pay crappy interest rates.

US Gov't:  You don't need to buy them.

Suckling Pig: Who is going to buy the bond then? 

US Gov't:  The Fed said they will buy them.

Suckling Pig:  Great, thanks for the kindness.  I am going to invest some of this money in commodities, buy groceries, go to movies and pay down debt.  Wait a minute, where does the Fed get the money to buy the bonds?

US Gov't:  Don't care as long as someone gives us cash.

Suckling Pig:  Hey Fed, where do you get the money to buy these bonds?

Fed:  In theory, the only money we really have is our member banks deposits.  But in this case, we don't have enough, so we are going to cover the rest.

Suckling Pig:  Cover the rest with what?

Fed:  QE2

Suckling Pig:  Yeah, but where does the money come from? 

In this scenario, $2 billion was just created with nothing.  How is this not inflationary?

I am just not getting this. 

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#2) On January 29, 2011 at 3:02 PM, rd80 (98.28) wrote:

The Fed purchases Treasuries in order to soak up excess reserves.

I think you have this reversed.  The Fed sells treasuries to soak up reserves.

 

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#3) On January 29, 2011 at 3:06 PM, binve (< 20) wrote:

dbjella,

I agree, this is a confusing issue. The problem is trying to analyze this problem from a pre-fiat mentalility (which I admit I have been confused about in the past).

I will offer a few clarifications based on how I understand things. Much of this just defines the operational reality of how things work. It is not agreement or validation of how things run. This is a good example of how I see things: http://caps.fool.com/Blogs/the-us-treasury-and-the/452537. I really think the old Fed / Treasury duo is the problem. We no longer need both institutions and the coziness that the Fed has will Wall St. is a huge reason why we had the crisis to begin with (and will likely have another).

>> Suckling Pig:  Really?  Where you going to get the money?  Cuz, you have spent all your tax revenues.

This is not true anymore. Taxes don't fund anything. They are not revenue. Just like selling Treasury bonds are not revenue. They used to be. But since 1971 in a completely fiat world they are not.

Taxes 'theoretically' are a way to drain excess capacity out of the economy. They are a planning tool. The problem is, it is used completely inefficiently. But that is another rant for another time.

So neither taxes nor Treasury bonds are revenue.

>>US Gov't:  Don't care as long as someone gives us cash.

This is another problem. The USG is not revenue constrained. It does not receive revenue that it is then limitied against for budgetary purposes. It spends first, and taxes later.

This might seem like a vague point, but it is not. Please read: http://caps.fool.com/Blogs/the-matter-of-deficits/435457 and http://caps.fool.com/Blogs/do-deficits-matter-debt-and/436169.

So the two points I discussed above are very important, and I am convinced describe the operational reality of how the USG/Fed/Treasury work.

I am not saying it is good, I am not saying it is bad (well, you can guess which way I lean), I am just saying what it is.

We can't apply convertible currency macroeconomic fiscal and monetary priniciples to a competely fiat currency system.

In the case of QE, it is not inflationary, because the reserves already exist. In the case of other everyday operations, you must be cognizant to distinguish between horizontal and vertical money creation: see http://pragcap.com/the-concept-of-vertical-and-horizontal-money-creation. So some monetary activity is inflationary while others are not.

In the case of the bailouts, that was an inflationary act. Congress authorized the creation of money to pay for Wall Street losses. It happened in the midst of a deflationary / deleveraging cycle which is why it didn't read as inflationary. But that is an example of vertical money creation. 

But rhetoric like "China bailed out Wall St." is incorrect. Treasuries are not a funding source. The USG spent the money into existence, just like it does on any spending project.

The crux of the matter is: at what pont does this matter?

If what I described was true without any repurcussions, then why doesn't every American receive $1million as an Act of Congress?  Obvivously because vertical money creation (exogenous to the banking system) must be in proportion to actual economic productivity.

But the USG has been able to 'get away' with some otherwise inflationary acts the past few years because we have a major private sector balance sheet recession. Literally trillions of dollars of private sector debt that has either defaulted or is non-performing (and will eventually default).

The real problem I have with all of this is that the Government economists / the Fed are trying to view this problem in terms of closing the output gap and to ramp financial activity back to pre-crisis levels. But they are not even considering how much of that economic activity was non-productive to begin with!

There are many productive areas of the economy that are either stagnating or not operating at their full potential because the Fed is trying to 'keep asset prices higher than they would otherwise be' by pumping the system with excess liquidity.

Financial engineering is not the road to prosperity and the same mistakes are being made again..

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#4) On January 29, 2011 at 3:14 PM, Valyooo (99.40) wrote:

Theoretically yeah you are right.  But do you really think the fed has all of these reserves, and has had an unchanging reserve for its history?  Or do you think its "reserves" are whatever it decides to print?

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#5) On January 29, 2011 at 3:18 PM, binve (< 20) wrote:

rd80,

Yep, you are correct.

The Fed reserve forecasters and the Treasury discuss how much excess reserves there are and how many Treasuries need to be bought to maintain their target rate.

The point I was trying to get at is that Treasury auctions and purchase or sale of treasuries by the Fed is a completely co-ordinated activity (by design) simply done to maintain control of their target rate..

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#6) On January 29, 2011 at 3:23 PM, binve (< 20) wrote:

Valyooo ,

>>But do you really think the fed has all of these reserves, and has had an unchanging reserve for its history?

That is a somewhat loaded question. Because the role of the Fed has changed since it inception. How the Fed and Treasury acted when we were still on a Gold Standard is different than how they act now that we are on a 100% fiat currency regime.

Beyond that, excess reserves simply need to be drained by monetary operations now. See my response to rd80 and dbjella..

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#7) On January 29, 2011 at 4:36 PM, portefeuille (99.60) wrote:

I only scanned the above for around 1 minute and think I should write about macroeconomics even less than I do about biotech (almost everybody else should do that as well). I think not mentioned above (excluding the linked stuff) is that quantitative easing is a way of "increasing bank lending" ("raise bank reserves and get the banks out of treasuries") which I think is also the main message of this little talk ...

Quantitative easing from Marketplace on Vimeo.

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#8) On January 29, 2011 at 4:39 PM, portefeuille (99.60) wrote:

#7 from here.

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#9) On January 29, 2011 at 4:42 PM, portefeuille (99.60) wrote:

#7,8 somewhat similar talks are here.

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#10) On January 29, 2011 at 5:08 PM, binve (< 20) wrote:

portefeuille,

>>is that quantitative easing is a way of "increasing bank lending"

Except that is not happening. See here

Total borrowing has continued to decline:

..

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#11) On January 29, 2011 at 5:16 PM, portefeuille (99.60) wrote:

#10 Well, some thinks increase bank lending and others decrease it. The talk made no prediction on which side would win over certain time periods. I think ...

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#12) On January 29, 2011 at 5:17 PM, portefeuille (99.60) wrote:

thinks

things

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#13) On January 29, 2011 at 6:49 PM, rfaramir (29.31) wrote:

Binve,

You seem to have bought into MMT or Chartalism. Things are not much different from pre-1971, except that the US has become less moral, no longer fulfilling its obligation to pay its debts in gold.

The real world will stop using Federal Reserve Notes if the Fed creates too many. It creates them for the government to spend. Like when you say the "USG spent the money into existence", it is really shorthand for the USG deficit spends, issues Treasuries to cover the deficit, and finally the Fed creates money to purchase the Treasuries.

Just because the Fed no longer redeems FRNs for gold (nor does the Treasury), doesn't mean the world's market will tolerate this behavior on 'our' part forever.

You are technically right when you say buying Treasuries is not inflationary, IF AND ONLY IF you ignore the creating of the reserves just before spending them. But they DO create the $600B before buying $600B in Treasuries, or else you couldn't say they added $600B of Treasuries to their balance sheet. The creating the reserves is 'printing' (electronically), not the buying Treasuries with the new reserves. The buying is not inflationary, but it couldn't have happened without the creating, which is. They created the reserves in order to buy, so QE(n) IS inflationary, just not the small part of the process which is the buying of Treasuries.

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#14) On January 29, 2011 at 7:05 PM, binve (< 20) wrote:

rfaramir,

>>You seem to have bought into MMT or Chartalism. Things are not much different from pre-1971, except that the US has become less moral, no longer fulfilling its obligation to pay its debts in gold.

I have had this discussion with many others (most notably David [whereaminow]). Please read my response #3 above to dbjella. Especially read this comment on David's blog: http://caps.fool.com/Blogs/its-called-a-jump-to/522770#comment522948.

My point in discussing the MMT viewpoint is that I have done a lot of studying of this issue over the last several years, and I believe it most accurately describes the operational reality of our current monetary system.

I differ greatly on some of the conclusions that many MMT propenents offer in regard to our current economic malaise.

They state because we are in a balance sheet recession, we don't have to worry about inflation and we can just perform defecit spending until we close the output gap.

I think this is erroneous on a number of levels. The real problem I have with all of this is that the Government economists / the Fed are trying to view this problem in terms of closing the output gap and to ramp financial activity back to pre-crisis levels. But they are not even considering how much of that economic activity was non-productive to begin with!

It is not a solution, because simply spending money by itself does not generate sustainable economic growth. This is precisely why the behemoth of investment banks led to the last crisis and why the bailout of primarily the IB's has not solved anything.

Also the viewpoint of many MMTers is that government was never too large or too ineffecient relative to the size of the economony that we have now, or the one that we had back in 2007. Again, I think this is highly flawed thinking.

There is nothing about the causes of the last crisis that were fundamentally fixed. See my thoughts here: http://caps.fool.com/Blogs/intermediate-term-bullish/526187 and especially here: http://caps.fool.com/Blogs/why-i-hold-gold-why-i-am-a/402614

Until we have policies that really start to solve problems, I will hold Gold.

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#15) On January 29, 2011 at 7:14 PM, devoish (98.36) wrote:

I think this is erroneous on a number of levels. The real problem I have with all of this is that the Government economists / the Fed are trying to view this problem in terms of closing the output gap and to ramp financial activity back to pre-crisis levels. But they are not even considering how much of that economic activity was non-productive to begin with!

+1 rec

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#16) On January 29, 2011 at 7:30 PM, binve (< 20) wrote:

devoish,

Thanks man..

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#17) On January 29, 2011 at 10:51 PM, ikkyu2 (99.15) wrote:

Your argument contains some solecisms.  You make the point that the economy behaves differently under fiat because long-term issuances of debt are used as primarily a fiscal tool.  Then you point out that something used to inject short-term liquidity cannot create inflation in the long term.  Then you turn right around and point out that long-term rates are rising.  You have done this with a mix of your own words, stuff copied from others, and links, some of which are broken.

You would do better to focus on what the Fed calls the 'effective' rate.  Since yield rates cannot be lowered below zero, asset purchases are used to drive prices up until the effective yields are below zero.  At one point during QE1 the effective fed funds rate was estimated to be negative 5.5% because free money was being piped in at such a rate.  

The result of this is long term rises in prices and yields.  For this not to be inflationary, the economy has to outgrow these changes over that long term.  Do you really believe this will happen? 

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#18) On January 29, 2011 at 11:54 PM, checklist34 (99.70) wrote:

QE would only result in money being printed if the fed simply didn't get paid back for its bonds when they expired and monetized them.

As of right now, in its current iterations, QE has not printed any money.

my entire last blog was sarcastic in its calling of Bernanke "evil" and so forth.  

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#19) On January 30, 2011 at 12:15 AM, binve (< 20) wrote:

ikkyu2,

>> You make the point that the economy behaves differently under fiat because long-term issuances of debt are used as primarily a fiscal tool.

Incorrect. That is the exact opposite of the point I made at the top of my post. Long term issuances (or any term issuances for that matter) are not a financing tool. Treasury operations are a monetary tool. In a fiat world that's all they are.

>>Then you point out that something used to inject short-term liquidity cannot create inflation in the long term.

That depends on the nature of the injection. In the case of QE, no it does not create inflation, based on how the program is structured (it is just an extension of normal Fed/Treasury operations). But if Congress were to enact a policy where say everyones bank account was credited with 1 million $, then that would obviously be inflationary. It is important to consider the nature of the injection, whether it is vertical or horizontal money creation.

>>Then you turn right around and point out that long-term rates are rising.

Because they are

>>You have done this with a mix of your own words, stuff copied from others, and links, some of which are broken.

I give credit to all sources, including my own work which I have linked to.

checklist34 ,

>>As of right now, in its current iterations, QE has not printed any money.

Very much agreed.

>>my entire last blog was sarcastic in its calling of Bernanke "evil" and so forth.  

When I read the post, I got your intention. I understood you were being tongue and cheek.

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#20) On January 30, 2011 at 12:47 AM, awallejr (81.59) wrote:

Heck of a blog.  +1 rec.  I tried in the past to discuss Libor but never seemed to get much attention.  I do think this a valid question by  ikkyu2, however:

The result of this is long term rises in prices and yields.  For this not to be inflationary, the economy has to outgrow these changes over that long term.  Do you really believe this will happen? 

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#21) On January 30, 2011 at 1:24 AM, checklist34 (99.70) wrote:

i maintain that a third deflationary scare/panic won't be avoidable before this secular bear draws to a close...

and then maybe a 4th...

m3 is still contracting as debt is reduced, and for all of the yelling, actual money printing to replace or exceed the contribution to thte money supply of the falling debt isn't occurring, the overall forces sans speculation in the marketplace and other things running up commodity prices, are deflationary.  

I don't expect "deflation" ala david's definition, so, all, we can avoid that argument, lol.  

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#22) On January 30, 2011 at 2:50 AM, whereaminow (20.75) wrote:

binve,

When you say that the purpose of QE is to keep asset prices artificially high, but that QE is not inflationary, are you saying the Fed expected QE to be inflationary but it actually isn't? And hence, that it actually isn't keeping asset prices artificially high?

I think the MMT concept of inflation (which seems to skip back and forth between price inflation and monetary inflation) is the sticking point.

Excess capacity, a macroeconomic aggregate with no relationship to actual human economic activity, is their measuring stick for inflation. That's going to cause them some problems.

As for QE, it appears they look at t=0 and declare that nothing has changed. But what happens at t=1?  Because now you have a new alignment of asset classes, which causes a new subjective evaluation of the holders of those assets.  PragCap doesn't seem to care or understand that humans make exchange decisions based on subjective factors. Shuffling the deck does have an impact. If it didn't, why shuffle it?

David in Qatar

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#23) On January 30, 2011 at 2:52 AM, whereaminow (20.75) wrote:

Checklist,

It ain't my definition, brother. It's the definition.

David in Qatar

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#24) On January 30, 2011 at 4:34 AM, DarthMaul09 (29.65) wrote:

An interesting conversation but why not debate whether Hell is like the surface of the Sun or as cold as deep space.  Either option is not good.  Prices are rising around the world, hence the food riots and general unrest, but if you don't want to label it the "I" word, that is OK.  With the Davos crowd taking about injecting another $100 Trillion dollars into the world over the next decade, it seems unlikely that the central banks will hold together long enough to make this debate worth having.

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#25) On January 30, 2011 at 9:18 AM, binve (< 20) wrote:

awallejr ,

Thanks

>> I do think this a valid question by  ikkyu2, however:
>>The result of this is long term rises in prices and yields.  For this not to be inflationary, the economy has to outgrow these changes over that long term.  Do you really believe this will happen?

Yes, I do think the long term path will be inflationary. I did not answer the question because that was not the point of my post.

My post sought to answer "is QE inflationary?". And when you understand the mechanics, no it isn't.

However, over the long term, the policies of the US and it central bank are undeniably inflationary. Even post 1971 when we became a 100% fiat-only currency.

Right now we are in a private sector balance sheet recession, so things like the Wall St. bailouts don't read as inflationary right now. But it was a highly inflationary act.

There are economic reasons for inflationary policies and there are political ones. They don't necessarily have the same aim. I do fully expect there to be inflationary policies in place where they can do more harm than 'good' (used loosely), and so yes I think the long term trend of the US is inflationary.

checklist34.

I agree. Right now monetary policy is spectularly ineffective and creating future instabilities in trying to close the output gap. And like I have argued above in some of the comments, it really has no business being close. The economy has some very productive parts (Tech in particular). Yet all of the Fed policies have been geared toward rebuilding the financial empire. Which is holding back growth in the productive parts of the economy, as the economy wants to contract and normalize to it. I think this is a failure.

whereaminow ,

Hey David.

>>When you say that the purpose of QE is to keep asset prices artificially high, but that QE is not inflationary, are you saying the Fed expected QE to be inflationary but it actually isn't? And hence, that it actually isn't keeping asset prices artificially high?

I think you know my viewpoint on inflation. Like I responded to awallejr above, the track history of the USG is undeniably inflationary.

The point of the post "is QE inflationary?", and when I dig into the mechanics, no it isn't.

So that sets up a few expectations.

If QE was actually inflationary, we would expect a persistent and permanenant increase increase in the money supply which will result in a persistent and permanent increase in prices.

However, since it isn't, I think the outcome is more dangerous. Since my argument above is that QE is not inflatonary, it merely increases liquidity (swaps interest bearing assets for cash), it is giving a 'liqudity goose' to assets. And my point is that this will end badly, as the liquidity will force assets to rise in price faster than their economic fundamentals can support.

This is not an MMT concept of inflation per se. This is my own pet theory in interpreting what's going on.

You know as we discussed before (see: http://caps.fool.com/Blogs/its-called-a-jump-to/522770#comment522948) that I agree with MMT only insofar as it describes the USG/Fed/Treasury interaction.

I differ greatly on some of the conclusions that many MMT propenents offer in regard to our current economic malaise.

They state because we are in a balance sheet recession, we don't have to worry about inflation and we can just perform defecit spending until we close the output gap.

I think this is erroneous on a number of levels. The real problem I have with all of this is that the Government economists / the Fed are trying to view this problem in terms of closing the output gap and to ramp financial activity back to pre-crisis levels. But they are not even considering how much of that economic activity was non-productive to begin with!

>>Shuffling the deck does have an impact. If it didn't, why shuffle it?

That is what I was illustrating above. Ben says that the goal of QE was to reduce long term interest rates. The opposite occurred. Either he is an idiot, or a different goal was at play. And that's what I was exploring.

And I am not comforted by my analysis.

Thanks!

DarthMaul09 ,

>>but why not debate whether Hell is like the surface of the Sun or as cold as deep space.  Either option is not good.

100% agreed.

The reasons why I went though this excercise was to think if it was inflationary, will it contribute to a permanent increase in price trends (which is the long term trends).

And I argue that no, QE is a liquidity goose that is contributing to price instability.

So I am not seeing any long term good, and a lot of long tem bad, that is resulting from QE..

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#26) On January 30, 2011 at 10:42 AM, outoffocus (23.08) wrote:

Binve,

Yes Banks are not lending as much but that doesnt seem to mean that QE2 is not inflationary.  Since many banks are allowed to be investment banks, they are allowed to speculate in the markets.  So who's to say (and I think theres enough evidence out there prove this) that banks arent taking their QE2 allowance and betting on commodities?  Banks have to make their money somehow and they arent acheiving that by lending.  So they make their money playing the slots, get three grapes and they win...while the rest of us lose...

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#27) On January 30, 2011 at 10:59 AM, whereaminow (20.75) wrote:

binve,

Thanks for the response. I have to admit that I'm a bit confused (and I hate that, because this sh*t shouldn't be rocket science).

I'll have to take some more time to study this, because I don't like this feeling.

David in Qatar 

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#28) On January 30, 2011 at 11:03 AM, binve (< 20) wrote:

outoffocus,

Hey!

>> So who's to say (and I think theres enough evidence out there prove this) that banks arent taking their QE2 allowance and betting on commodities?

I think that is precisely what is going on.

Here is my logic train

1) Fed initiates QE, which is compeletely internal to the banking system (no vertical money creation) and forces banks to swap interest bearing assets for cash. The net financial assets in the system is exactly the same after the transaction => not inflationary

2) However more cash => more liquidity sloshing around which makes in prone to speculation. And like I said above: "there is more liquidity sloshing around in the system. This means that risk assets are going to get a bid, and big time. And that is exactly what happened. There are many who called this, including most notably David Tepper, back in September and it is clear they were right. A few things had to happen to this to play out. Excess liquidity by itself does not necessarily mean that all risk assets get a bid. But with stocks in particular, all of dominoes did in fact line up: a) There had to be actual GDP growth occurring (which there has been) b) Earnings has to be growing (and they have been) c) Corporate balance sheets had to be improving (and they did)

3) We now have a non-inflationary (no increase in the money supply) program that increases liquidity to chase the same amount of assets. Assets get a bid and start rising faster than fundamentals support.

This is why I think this particular maneuvar will lead to another bubble and another crash. Likely not for a couple of years. But it is setting up price instability.

If it was inflationary, then it would be a presistent increase in the money supply and a presistent increase in prices. This is why I went to great pains to describe this a 'liquidity goose' and why I think it is leading to potential (but very likely) price instabililty (i.e. speculative money always flees at the first sign of trouble [economic slowing] => amplification on the downside).

>>So they make their money playing the slots, get three grapes and they win...while the rest of us lose...

I can't argue with that one single bit..

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#29) On January 30, 2011 at 11:10 AM, binve (< 20) wrote:

whereaminow ,

Absolutely man. This shouldn't be so confusing, but it really is.

I claim no superior knowledge, but I have been thinking and reading about this for many years and have been reading many different schools of thought. And I am convinced that most of Congress doesn't understand our monetary system, and I think more than a few economists don't either. (Hell, it could be that maybe I don't as well, and I am certainly not precluding that possibility). So I think there are a lot of conflicting economic and monetary signals occurring.

But when I follow the logic of monetary operations of the last 2 years, I come to the conclusion that price instability (=> another bubble and another crash) is the likely outcome for the next 5-10 years and very high persistent inflation is less likely. I do think that very high persistent inflation is certainly in the cards beyond that, but I think things are much less straightforward before we get there

>> because I don't like this feeling.

me neither :(.

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#30) On January 30, 2011 at 10:33 PM, ajm101 (31.87) wrote:

Almost forgot, but great post.  Going to catch up and read it now... thank you!

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#31) On January 30, 2011 at 11:43 PM, binve (< 20) wrote:

ajm101 ,

Thanks ajm!..

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#32) On February 01, 2011 at 2:17 PM, Melaschasm (56.85) wrote:

Technically QE2 is reflationary, not inflationary. 

Put simply, when the government demanded banks put money (reserves) into the FED, that was deflationary (it removed money from the economy).  Now that QE2 is returning that money to the economy it is reflating. 

For all practical intents and purposes, reflating is the same as inflating, thus those complaining that QE2 is inflationary are basically correct.

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