Is QE Inflationary?

The answer to the question posed in the title of this article is unquestionably “yes” – Quantitative Easing (QE) is most definitely inflationary, although there is certainly no lack of modern-day Keynesian economists who will be quick to disagree with this obvious fact. As was pointed out in a previous article (see What’s Money? What’s Not?), there are many analysts with vastly differing ideas of what constitutes money, and according to the definition used by many of the New-Keynesians economist today, QE is not inflationary at all – it is merely an swap of one type of dollar-denominated asset for another.

As the argument goes, when the Fed buys bonds in the private market, they may well be “printing money” to fund the purchase, but in the process they are taking another financial asset of equivalent value out of the market. Because these bonds should be considered “money-like” the QE process merely constitutes an asset swap where the Fed is trading out more liquid money for less liquid “money”. The swap leaves the same value of financial assets in the market, but is merely just changing the composition of the “money” available. In doing so, the Fed adds market liquidity without causing inflation.

The above argument works well enough if you accept the conclusion that bonds are essentially money. This, however, is a false assumption with little correspondence to how the real world actually works. As has already been stated numerous times in past articles, any analysis of economy-wide liquidity is doomed to fail without a rigorous definition of what actually constitutes money. To recap, money consists of notes and coins in circulation plus money-substitutes. Now virtually nobody argues about the inclusion of notes and coins in circulation, but what precisely constitutes money-substitutes is sometimes subject to a more contentious debate. While it is understandable that there exists some argument among reasonable people over savings accounts or even money-market funds, there should be next-to-no debate whether or not bonds fit the definition of money-substitutes.

Briefly, money’s purpose is as a means for consumers to transact against goods and services in the economy. It is the final medium of payment that completely extinguishes the debt of the purchaser. Money substitutes, then, must be fully and instantly redeemable and fully secure claims against standard money. This is the reason, for example, why credit cards are not money, for there is an intermediate transaction involved whereby the debt of the consumer is no longer owed to the seller of the product, but is transferred to the credit card company. It is the payment of money from the consumer to the credit card company that completely extinguishes the debt and where the transaction is at last completed.

Similarly, in order to use a financial asset (such as a bond) to make a purchase at, say, the grocery store, the consumer must first engage in an intermediate transaction whereby they sell the security at whatever value is determined by the open market. The transaction then typically goes through a settlement period before the money is available in the consumer’s brokerage account, which must then be transferred from the brokers account to the consumers bank account in the form of deposit money. Only at the end of the process, can actual deposit money be used as a form of final payment against whatever goods and services the holder deems necessary. Bonds, which are clearly unsecure assets that are not instantly redeemable, are unquestionably not money.

Of course, it is this deviation from a strict definition of money that gets many economists in trouble in the first place, for it is impossible to argue that certain less-liquid assets should be considered money while other non-liquid assets should not be. Why, for example, should one be content to stop at bills, GIC’s, or bonds? Why not include stocks, or real estate in the money supply as well? Certainly if one were to relax their definition of money it is possible to argue (as some economists do) that QE has no inflationary impact whatsoever, which is implicitly what many analysts are unknowingly doing by using “broad” measures of money to form their conclusions regarding inflationary and deflationary forces in the broad economy.

When the Fed undertakes QE, they add money to the economy (or “liquid” money, in Keynesian-speak), and remove a financial non-money asset by extinguishing the bonds from the private market. Consequently QE removes “something” from the economy and injects newly-printed money in its place, resulting in a condition of more money chasing fewer goods which is a process that in the long run is most assuredly inflationary. In a similar manner, the removal of QE exerts a deflationary force on the economy, regardless of the fact that today’s crop of New-Keynesian advocates will claim this process to be largely sterile.

The fact that QE did not ultimately result in significantly higher prices among certain consumer items measured by the CPI is not evidence that economy-wide prices did not significantly increase in aggregate. For example, while prices may not have increased significantly for a selected basket of consumer goods and services, the same cannot be said for real estate prices in Vancouver or Toronto, or equity prices for publicly traded companies on the Dow or S&P500. Rather than looking towards correlations between QE and the CPI to validate their dogmatic pre-conceived notions of what constitutes money, Keynesians would do well to first focus on the very identity of money itself before coming up with fantastical theories that defy any common-sense real-world application of money to average people.