15 May 2015

Peterson Institute: Quantity Theory of Money Redux? Will Inflation Be the Legacy of Quantitative Easing?

The most likely aftermath of quantitative easing remains one of benign price behavior. However, if nascent inflationary conditions were to materialize, the Federal Reserve would need to manage adroitly the large amounts of banks’ excess reserves that have accumulated as a consequence of QE.

Since the onset of the Federal Reserve’s unconventional program of large scale asset purchases, known as quantitative easing (QE), some economists and financial practitioners have feared that the consequent buildup of the Fed’s balance sheet could lead to a large expansion of the money supply, and that such an increase could cause a sharp rise in inflation.

The Federal Reserve implemented QE to address the need for additional monetary easing in the Great Recession once interest rates had already reached the zero bound. Other major economies have also adopted QE, first the United Kingdom and subsequently Japan and the euro area.

So far fears about induced inflation have not been validated. If anything, the problem has been too little rather than too much inflation, as judged against the Fed’s benchmark targets. This Policy Brief examines the basis for the original concerns about inflation in terms of the classic quantity theory of money, which holds that inflation occurs when the money supply expands more rapidly than warranted by increases in real production.

The Brief first reviews the US experience and shows that whereas rapid money growth might have been a plausible explanation of inflation in the 1960s through the early 1980s, thereafter the data have not supported such an explanation. It then shows that the quantity theory of money has not really been put to the test after the Great Recession, because the Federal Reserve’s balance sheet has not translated into money available to the public in the usual fashion.

The Brief concludes that the most likely aftermath of quantitative easing remains one of benign price behavior. It warns, however, that if nascent inflationary conditions were to materialize, the Federal Reserve would need to manage adroitly the large amounts of banks’ excess reserves that have accumulated as a consequence of QE in order to limit inflationary pressures. 

Full article on Peterson Institute for International Economics.

© Peter G Peterson Institute for International Economics