There is currently an argument that if the Fed were to restart QE, it would lead to inflation increasing before the Fed got inflation back to its 2% target.
In this report, we dig into the mechanics of QE, the correlation between QE and CPI, and possible causal outcomes from QE impacting inflation.
Breaking down QE
To understand how the mechanisms of QE could affect inflation, we must first deeply understand the mechanics of how QE itself works.
Since 2008 when interest rates hit zero, the Fed began to engage in Quantitative Easing, commonly referred to as QE.
The Federal Reserve initiates QE by purchasing a substantial amount of financial assets, typically treasury bonds or mortgage-backed securities, from the open market. The Federal Reserve transacts with a group of financial institutions known as primary dealers. These dealers are authorized to trade directly with the Fed in the open market and include major banks and securities firms. The primary dealers act as intermediaries between the Federal Reserve’s NY Trading Desk and the broader financial markets.
As these primary dealers bid to the Fed, it determines the purchase price based on the bids received. The goal is to inject a specific amount of money into the banking system and the accepted bids become the basis for the transaction prices, and the Federal Reserve credits the accounts of the selling institutions with the purchase amount. As the Federal Reserve acquires these assets, it credits the accounts of the selling institutions with newly created reserves, called Central Bank Reserves. This process effectively adds to the banking system's reserves, increasing the overall money supply.
This QE process causes a few things to occur:
Lowers longer term interest rates:
Since the Fed can only directly control the short end of the cure through its FFR, it uses QE to attempt to influence the longer end of the curve. By flooding the banking system with reserves, QE aims to lower interest rates. As the supply of money increases, the cost of borrowing decreases, making loans more affordable for businesses and consumers. This, in turn, stimulates spending, investment, and economic activity.
With the increased supply of money in the financial system, investors may seek higher-yielding assets, such as stocks or corporate bonds, as traditional fixed-income investments offer lower returns. This leads to a rebalancing of investment portfolios, fostering risk-taking behavior in financial markets.
Increasing loan activity:
As the Federal Reserve completes these transactions, it adds reserves to the banking system. These newly created reserves provide banks with additional funds that can be used for lending and investment. The increase in reserves contributes to the overall expansion of the money supply.
Breaking down CPI
When a debt based economy grows, generally it creates inflation, or an increase in prices.
The idea is for the CPI index to track this change in prices. The CPI basket is primarily composed of the following:
From these, let’s take a look at how QE could potentially affect the biggest components of the index:
Direct Impact: QE can indirectly influence the housing market. By lowering long-term interest rates, QE tends to make mortgages more affordable, encouraging homebuying and potentially driving up housing prices. Rising housing prices can contribute to higher shelter costs within the CPI basket due to the trickle down effect into rents from home prices.
Wealth Effect: QE may lead to an increase in asset prices, including real estate. As people feel wealthier due to higher home values, they might be more willing to spend, leading to increased demand for goods and services, including housing. This demand can push up rental prices and contribute to higher shelter costs in the CPI.
Interest Rates and Investment: QE can lead to lower interest rates, which may stimulate investment in energy-related projects, such as exploration and production. Increased investment can contribute to higher energy prices. However, due to ESG investing pressures, we have actually seen the opposite of energy investment - energy divestment.
Commodity Prices: QE can impact commodity prices, including those of energy-related commodities like oil and natural gas. As the money supply increases, it can lead to higher demand for commodities, potentially raising their prices and contributing to higher energy costs in the CPI.
Input Costs: QE can affect agricultural commodity prices through changes in interest rates and overall market sentiment. Lower interest rates can reduce the cost of financing for farmers, potentially leading to increased production costs. This may be reflected in higher food prices.
Currency Depreciation: QE can influence exchange rates, and a depreciating currency can make imported goods, including food, more expensive. This could contribute to higher food prices within the CPI basket.
It should be noted these are qualitative inferences and not outright causal effects. Causality in itself between QE and CPI is very difficult to prove. That said, we can further look at correlation between the two when we compare them on a chart:
What we see in the chart above is that CPI and an increasing Fed balance sheet are positively correlated 54% of the time, and negatively correlated 46% of the time.
In essence, the correlation is shaky and only positive half the time. Effectively, we can consider the rolling correlation as noise.
In summary, does QE create inflation?
It’s difficult to prove the causality of such a policy, but the correlation is spurious at best.
Although the qualitative analysis of how QE could trickle into CPI components looks sound on its own, in actuality we see very little consistent correlation between the two.
Many believe that if the Fed were to begin QE again it would lead to a rebound in CPI inflation undoing all their recent work. Hopefully this analysis helps showcase the fact that it's not so simple and much more nuanced to the point where there is no solid reasoning for believing in such an outcome so absolutely.
Disclaimer: This research report is exactly that — a research report. It is not intended to serve as financial advice, nor should you blindly assume that any of the information is accurate without confirming through your own research. Bitcoin, cryptocurrencies, and other digital assets are incredibly risky and nothing in this report should be considered an endorsement to buy or sell any asset. Never invest more than you are willing to lose and understand the risk that you are taking. Do your own research. All information in this report is for educational purposes only and should not be the basis for any investment decisions that you make.