Does QE Create Inflation?
The relationship between Quantitative Easing (QE) and inflation has long been a subject of debate. In principle, massive increases in the money supply are expected to be inflationary. However, until recently, we also observed decreases in the velocity of money, which prevented inflation.
Role of the Money Supply and Velocity
Until the recent period, the primary cause of inflation is attributed to the significant 40% increase in the money supply in 2020–2021. Various factors, such as the pandemic and the war in Ukraine, have certainly influenced specific price increases, but they are not the primary root of overall inflation. Inflation, in its true form, refers to an overall increase in the prices of all goods, not just specific goods caused by changes in supply and demand.
Historical Context and Federal Reserve Actions
Quantitative Easing was first widely used during the 2008 financial crisis. Following this, the U.S. experienced the slowest economic recovery in history, with no evident inflation. In December 2018, the Federal Reserve raised their target range for the federal funds rate by 0.25 percentage points to 2.25-2.50, expecting a pickup in inflation.
However, the economy slowed dramatically, far below what was anticipated. In response, the Federal Reserve raised interest rates by 0.25 percentage points three times in 2019. The Federal Reserve subsequently conducted an internal review and concluded that interest rate hikes should only occur in response to data-driven requirements and not in anticipation of inflation.
Monetary Phenomenon and Inflation
The influential economist Milton Friedman famously stated, "'Inflation is always and everywhere a monetary phenomenon.' This means that creating money through QE inevitably leads to inflation, albeit with a time lag.
Busting Myths with Rationale and Evidence
That being said, it is essential to address some of the misconceptions surrounding QE and inflation. The argument that every instance of QE involves cash and a significant increase in the money supply is incorrect. QE once involved massive expansion of the central bank's balance sheet without necessarily involving cash, and with minimal effect on the money supply.
It is also crucial to understand that the obsession with 'money supply' is often misplaced. Americans do not have trillions of dollars 'just flowing around' or sticking out of their pockets. The idea that inflation is solely a result of capitalist greed is a prevalent but flawed perspective. Inflation is a broader monetary phenomenon that affects the economy as a whole, not just individual capitalist enterprises.
In conclusion, while QE does have the potential to create inflation, the actual impact depends on various economic factors such as the velocity of money and the overall economic environment. Understanding and managing these variables is crucial for policymakers and economists alike in ensuring stable economic growth and price stability.