Does Quantitative Easing Cause Inflation?
It seems that there is a lot of confusion in economic circles over quantitative easing and its influence (or not) on inflation. There has clearly been a sharp rise in the US inflation rate in recent months, as well as in other western economies, but there is a great deal of controversy regarding its cause.
At the start of 2022 there does seem to be a reasonably broad, but by no means universal, agreement that our western economies are in big trouble. Some commentators foresee a deflationary depression in the near future, others foresee an inflationary depression. Let me state upfront that I fall into the latter group of doom-mongers.
With that in mind, I’m going to address some of the key points that the deflationists make with regard to the money-supply, quantitative easing, and inflation. I’ll start with a refresher on the quantity theory of money, because it is much misunderstood and it really gets to the heart of the matter:
This simple equation tells us that the money supply (M) multiplied by the velocity of exchange (V) is equal to the price level (P) multiplied by the total output of goods & services (Y) in an economy over a given period of time (usually a year). There’s no controversy here, this is a simple economic accounting identity.
Furthermore, following the work of Milton Friedman, we are reliably informed that V and Y are relatively stable in most circumstances, and that any increase in M will therefore show up as an increase in P i.e., inflation. This is still standard stuff, but recent bizarre comments from Jerome Powell (Chairman of the Federal Reserve) indicate that there is a lack of understanding on even this basic principle of monetary economics.
I won’t focus on such foolish comments, because I get the impression that they are significantly influenced by political forces rather than economic reality.
What I do want to focus on are the much more credible remarks coming from one of the most respected economists on the deflationist side of the debate i.e., Dr. Lacy Hunt. Before I do that, let’s have another think about the quantity theory of money equation.
Errors Applying Quantity Theory to Quantitative Easing
It seems like common practice to use the monetary aggregate M2 as a proxy for M, CPI as a proxy for changes in P, and GDP as a proxy for PY. However, V has no proxy, and is simply derived from working out the other proxies. This, of course, raises some serious calculation errors.
The biggest issue with regard to increased quantitative easing (QE) measures is that, whilst it increases M2 proportionately, to date it has only increased the money supply in the real economy to a much smaller extent. Most of the QE has not entered the real economy and has instead been used by the banking sector to purchase financial assets. Such purchases do not influence GDP, and so it makes little sense to use both M2 and GDP as proxies in the same accounting identity.
Furthermore, whilst CPI has risen, it has failed to accurately reflect the true extent of the rising price level, because some of the most important items that people buy are not even included in the CPI representative basket of good & services. Real estate costs, for example, are excluded from the CPI measure of inflation.
In other words, if we are to use GDP as our proxy for PY, the calculation errors in estimating changes in M & P via changes in the M2 and CPI proxies are so large that any hope of being able to derive a sensible estimate of V is total delusion.
Whilst this may all seem academic, it’s not. Belief in a falling velocity of money forms the bedrock of the deflationist position with regard to their economic forecasts.