Steve Bain

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.

The Deflationist Argument about Quantitative Easing and Inflation

I should point out here that I do have the greatest of respect for Dr. Lacy Hunt and other prominent economists who support the deflationist point of view, but I believe that point of view to be deeply flawed.

In his December YouTube interview with Danielle DiMartino Booth, Dr. Hunt states:

  • 6:05 – That increasing indebtedness since the 1980s has led to falling Velocity
  • 6:55 – That the extra (QE) money supply is ‘trapped’ in the financial markets

On the first bullet point, velocity has actually only been falling since the inception of QE in 2008, as illustrated by the Federal Reserve Graph of Velocity. Up to 2008, velocity had actually been at a historically high level with no sign of decline since the 1980s.

On the second bullet point, and this the crucial point, the extra money is not trapped. It has only been lured by the attractive returns on financial assets during the ‘everything bubble’ (the largest bubble ever recorded according to the ‘buffet indicator’). When expected returns on those assets turn bearish, and many of our most accomplished investors think that to be imminent, that money could easily enter the real economy, causing massive inflation as a result.

There were many more points made by Dr. Hunt to support his view, and I’d recommend viewing the entire video as it is full of entertaining and thought-provoking ideas, even though I can’t agree with his outlook on inflation/deflation.

Conclusion - QE Does Cause Inflation... eventually!

The role of quantitative easing in causing inflation has been distorted by calculation errors in the proxy measures used to represent the economic accounting identity MV=PY. This has led to serious errors in the estimation of money velocity in the real economy, and we have good reason to doubt that it has collapsed to the extent presented by the Federal Reserve. What we do know is that the reported decline in velocity coincides exactly with the introduction of QE measures.

The rate at which the money supply in the real economy has grown has been overestimated by M2 because, as Dr. Hunt correctly points out, much of the M2 growth has not entered the real economy and has instead entered the financial asset market – something that is external to the Quantity Theory of Money. Whether or not that M2 money supply will remain in the financial asset market once the current bubble there has popped is far from certain, but seems quite unlikely once expected returns on those assets become bearish.

In answer to the question ‘does quantitative easing cause inflation?’, the answer is most definitely yes once it eventually reaches the real economy, and as pointed out that does seem likely to happen soon.

Disagreements about whether the economy will enter a deflationary depression, or an inflationary depression (i.e., potentially a ‘crack-up boom’) are not settled, but there is broad agreement that a depression of one sort or another is coming – at least among most economists whose minds are free of political ideology.

There is also broad agreement that it is the existing fractional reserve banking system that is largely to blame for the mess that we have been in since the 2008 financial crisis, and all the malinvestment that has occurred because of it. Hope springs eternal that one day we might adopt a sound money alternative.

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