As regular readers are no doubt aware, I’ve often argued against the notion that QE operations conducted by the Bank of Canada are inherently inflationary, since no new money is actually “printed” as a result. More specifically, when the Bank of Canada purchases assets in the secondary market from commercial banks, they do so not by creating the type of money that you and I hold in our savings and chequing accounts, but by creating a different type of money called “reserves” within the banking system. Reserves, of course, only ever exist in reserve accounts that are held at the Bank of Canada, and only commercial banks and the Government of Canada are privy to such accounts.
Banks use reserves (also called “settlement balances” here in Canada) to settle payments with one another, but the reserves themselves effectively live within a closed system. In other words, banks don’t ever transfer reserves to your bank account or mine since only the government and commercial banks hold reserve accounts at the Bank of Canada. Since these reserves don’t ever flow through to the deposit accounts that citizens hold within the banking system, I’ve often explained that QE’s creation of reserves isn’t “money printing” at all, and isn’t really inflationary in nature. After all, if reserves are only ever shuffled back and forth between commercial banks and never leave the closed system of reserve accounts, then these reserves are never really “spent” into the broad economy.
Or are they?
While the separation that exists between bank reserves and normal commercial bank deposits is certainly real, it appears that I’ve neglected one important fact. Namely, commercial banks can write cheques to the private sector against their reserves, and this has the effect of creating new deposit money within the economy, even if these reserves never leave the reserve accounts of commercial banks. To illustrate how banks effectively “spend” or “inject” their reserves into the broad economy, consider the following example.
Suppose that Bank A purchases a table from Peter, and Peter holds a chequing account at Bank B. In order to pay Peter for the table, Bank A writes a $500 cheque to Peter which he subsequently takes to Bank B to deposit in his chequing account. Upon receipt of the cheque, Bank B will create a new deposit of $500 in Peter’s chequing account, which is a $500 asset for Peter and a $500 liability for Bank B. It is a liability for Bank B because it is money owed to Peter at any time Peter demands it.
Of course, Bank B doesn’t just take on a new liability in isolation, it also needs a matching asset to make the transaction balance-sheet neutral. Bank A therefore transfers $500 from its reserve account at the Bank of Canada to Bank B’s reserve account at the Bank of Canada so that Bank B now has both a new asset of $500 (the reserves from Bank A) and a new $500 liability (Peter’s deposit at Bank B). The net result is a transfer of reserves from Bank A to Bank B, and a new bank deposit of $500 held in Peter’s account at Bank B.
Thus, while the reserves may have indeed remained trapped in reserve accounts at the Bank of Canada and not transferred to Peter’s deposit account, bank deposits still managed to grow by $500 as a result of Bank A’s spending. It follows that when the Bank of Canada purchases bonds from commercial banks in the secondary market and pays for these bonds be creating reserves, the selling banks can, in a way, “spend” their reserves through the creation of deposits within the broad economy. Does this then mean that QE, when it creates reserves for commercial banks, is inherently inflationary?
No, because the operation resulted merely in the exchange of a fairly liquid asset with an even more liquid asset, all the while keeping net wealth unchanged. The process of QE simply removes a bond asset from a commercial bank’s balance sheet and adds an equal value of reserves in its place. As the folks in the Monetary Realism camp have long argued, the operation ultimately just exchanges a form of less liquid money (the bond) with more liquid money (reserves).
There is no practical reason why the Bank could not in the first place have sold their highly liquid bond for money, and then spent this money if that had in fact been their original intent. The exchange of reserves for bonds does not by itself increase the propensity of the bank to spend these reserves back into the economy in a way that causes real inflation as measured by the CPI. Now, obviously the bank, which had a bond in the first place, now has reserves, so will likely want to rebalance their portfolio and spend those reserves to purchase other financial assets. This is what is referred to as the “portfolio rebalancing” impact of QE.
This process, of course, has the ability to boost asset prices elsewhere, which is really what the portfolio rebalancing channel is all about. Safe bonds become more expensive as a consequence, and investors move out on the risk spectrum and bid up asset prices elsewhere, which just drives down yields further. So the idea is that the recipients of QE money (banks) do spend their reserves to purchase other financial assets in the process of re-allocating their existing wealth, but they don’t necessarily spend their wealth into the economy to cause inflation. All they’re doing is simply re-allocating their existing savings. Why would the banks be more inclined to spend their wealth after QE than before? After all, the Bank of Canada didn’t give them more wealth to spend. It only changed the composition of their existing wealth.
If the above is true when the Bank of Canada purchases assets using reserves, then really, it should also be true when they purchase assets from the non-bank private sector using normal deposit money. If the Bank of Canada purchases an asset from the private sector by increasing someone’s money held in deposit at a commercial bank, then the actual broad money supply increases. But is that person going to immediately spend that cash into the economy and cause inflation, or are they going to take that cash and inject it right back into the bond or stock market? If they had wanted to spend the money on goods and services, what exactly was stopping them before QE? After all, they could have simply sold the bond for spendable cash, and spent away.
So it seems that a person’s ultimate spending power isn’t driven by their money balances per se, but by their net wealth. For example, someone who holds a relatively small balance of cash might at the same time hold significant financial assets. Simply changing the composition of those assets doesn’t alter a person’s ability to spend down their wealth on goods and services – actually increasing their net wealth does. By the same token, simply increasing someone’s wealth doesn’t automatically mean they will actually spend that wealth into the economy, even if they now have the capacity to do so. A person’s propensity to withhold their wealth is a significant determinant to the inflationary impact that such wealth can generate.
It turns out, then, that focusing on the money supply as a driver of inflation isn’t necessarily as helpful as one would think. Rather, we should instead focus on private sector net wealth. The reality is that a myopic focus on the money supply since the financial crisis of 2008 would have been extremely misleading, as much of its growth has been driven by QE asset purchases which simply alter the composition of private sector assets. The “hot-potato” effect set in motion through subsequent portfolio rebalancing has the effect of increasing the value of financial assets, yet people who hold financial assets already have a low propensity to spend their wealth, and so inflation has as a consequence been muted.
So how might the stimulus unleashed in response to COVID-19 actually cause inflation? Through government deficit spending, that’s how. An increase in the net wealth of the non-government sector directly corresponds to the government’s deficit. The government effectively has the capability to increase private sector net wealth and thus increase spending power in the economy, although it’s ultimately up to the private sector on whether they spend their newfound wealth or not. If the private sector were to significantly increase spending in the future without a corresponding increase in economic output to absorb this spending, inflation could very well be a problem. If, on the other hand, the private sector continues to hoard wealth rather than spend it, the current dis-inflationary environment can potentially continue far into the foreseeable future.