Why the Federal Reserve Will Launch Another Round of QE – Fending Off Powerful Deflation

By Richard Duncan

In November 2002, Fed Governor Ben Bernanke introduced the concept of Quantitative Easing to the world. In a speech entitled “Deflation: Making Sure It Doesn’t Happen Here”, he explained that the Fed could prevent deflation from taking hold in the United States by creating money and using it to acquire government and agency (i.e. Fannie Mae and Freddie Mac) bonds. He proclaimed that this “unorthodox monetary policy” would be particularly efficacious if carried out in combination with an expansionary fiscal policy.

With this speech, Bernanke reassured the banking industry and the rest of the speculating community of the Fed’s omnipotence. In doing so, he encouraged even more aggressive credit creation and risk-taking. As a result, the credit bubble, which had already grown quite large, became very much larger. When it imploded six years later, Fed Chairman Bernanke, in cooperation with Treasury Secretaries Paulson and Geithner, responded to the crisis using the exact policies Bernanke had described in 2002.

The Fed began printing very large amounts of money and using it to buy very large amounts of government and agency debt. The Treasury began borrowing and spending trillions of dollars, which it was able to finance at very low interest rates thanks to the Fed’s purchases of government debt. This combination of very aggressive fiscal and monetary stimulus prevented a new great depression and the horrific collapse in prices that would have accompanied it.

Therefore, while it should not be forgotten that Bernanke bears much blame for allowing this crisis to occur, it must also be acknowledged that he was correct when he declared the Fed would be able to prevent deflation through the aggressive use of unorthodox monetary policy.

Many financial commentators have noticed that bank reserves held at the Fed have increased by $2.9 trillion since early 2009. As this is equivalent to 83% of the amount of money the Fed has created during that period, they have concluded that almost all of the money created through QE has been stuck in the banks and therefore has had no impact on the economy whatsoever. This interpretation is incorrect, however.

Between 2009 and 2013, the government borrowed approximately $5.8 trillion to finance its budget deficits. During that time, the Fed acquired $1.9 trillion worth of government bonds. If the Fed had not bought those bonds, either the government would have had to spend $1.9 trillion less, which would have removed $1.9 trillion of aggregate demand from the economy, or else the government would have had to borrow the $1.9 trillion from the financial markets.

That would have drained liquidity from the system and pushed up interest rates (resulting in old fashioned Crowding Out). Higher interest rates would have pushed the collapsing property market down even further and damaged the economy in countless other ways. QE allowed the government to boost aggregate demand through deficit spending and to finance its deficit spending at very low interest rates.

The Fed also bought $1.7 trillion worth of agency debt or, in other words, the mortgage-related debt issued and guaranteed by Fannie and Freddie. That pushed up the price of those bonds and drove down their yields. By acquiring that debt at a much higher price than would have otherwise prevailed, the Fed helped restore the solvency of the crippled financial industry, which was then teetering on the edge of the abyss.

By pushing down the yield on mortgage-related debt, the Fed stopped the collapse in property prices and later, under QE 3, brought about their rebound. Higher property prices helped reflate the economy by pushing up household sector net worth. If the Fed had not bought $1.7 trillion worth of mortgage-related debt, the yield on that debt would have remained high (or moved higher), the owners of that debt would have been stuck with impaired assets and the property market would have weakened further instead of rebounding.

In these ways, QE greatly strengthened the economic fundamentals of the United States. Recognizing this, equity investors drove the stock market higher each time a new round of QE was announced. Surging stock prices also served to reflate the economy.

Between the rebound in property prices and the sharp rise in stock prices, household sector net worth increased by $25 trillion (or by 45%) from the low it reached in 2009. It is now 17% above its pre-crisis peak. This increase in wealth was the result of Quantitative Easing. What else could possibly explain it? That surge in net worth clearly created a wealth effect that allowed much more consumption and, therefore, economic growth, than would have been possible otherwise.

It was not a coincidence that net worth rose by $25 trillion at the same time that the central bank was creating unprecedented amounts of fiat money and using it to acquire financial assets. It is certain that QE reflated the US economy by pushing up asset prices. It is not at all certain, however, that the economy will remain “reflated” when QE ends in October. In fact, the odds are quite high that it will begin to deflate again.

Should that occur, the Fed would then have to decide whether to do nothing and allow everything it has accomplished to unravel in a process most probably leading back to severe recession and deflation or else to launch yet another round of Quantitative Easing. I believe it will be an easy decision for the Fed to make. After all, what’s a few trillion dollars more (shared) among friends?

Source: The Daily Reckoning