Can QEs Lead to Hyperinflation?

As the Great Recession set in, the Fed dropped its interest rate target to close to zero. Then it was forced to use unconventional monetary policy tools including quantitative easing (QE). QE was an emergency measure used to stimulate the economy and prevent it from tumbling into a deflationary spiral.

When financial institutions collapse and there is a high degree of economic uncertainty, people and businesses choose to hoard their money rather than risk investment and potential loss. When money is hoarded, it is not spent and so producers are forced to lower prices in order to clear their inventories. But why would somebody spend a dollar today when they expect that prices will be lower—and their dollar can buy effectively more—tomorrow? The result is that hoarding continues, prices keep falling, and the economy grinds to a halt.

The first reason, then, why QE did not lead to hyperinflation is because the state of the economy was already deflationary when it began. After QE1, the Fed underwent a second round of quantitative easing, QE2. Here the central bank undertook open market operations where it purchased assets from banks in return for dollars.

It is true the monetary base spiked during these initial rounds of QE, but the second reason QE didn't lead to hyperinflation is we live under a fractional reserve banking system whereby the money supply is more than just the amount of physical coins, paper money, and bank deposits in the system.

The monetary base, or M0, is money in circulation, but banks are in the business of making loans with the deposits on hand. The money from those loans are then deposited back into the banking system and re-loaned, over and over again. This is the so-called money multiplier effect.

If the multiplier is 10x, for every $100 deposited into a bank up to $1,000 of new credit money is created through this mechanism. The M2 measure of the money supply, which includes the effects of fractional reserve banking and credit, was actually quite stable during this period (in the U.S.).

So where did all the M0 money go if it wasn't multiplied through the credit system? Banks and financial institutions hoarded the money in order to shore up their own balance sheets and regain profitability. Banks still had bad loans and toxic assets on their balance sheets as a result of the housing bubble and its aftershocks. The extra cash on hand made their financial picture look a whole lot better. As the economy recovered and the Fed began tapering its interventions, the money being held by banks was returned to the Fed slowly in the form of interest payments on the debts purchased during QE. Meanwhile, the U.S. economy, on the whole, has remained productive and growing.

Many had feared that QE would spell hyperinflation for the U.S. economy following the economic crisis of 2008. The crisis, however, was largely a deflationary phenomenon and the money being injected into the system (by QE), as seen by the spike in the M0 monetary base, was by and large retained by the financial sector, with the more important M2 money supply remaining fairly stable.

Hyperinflation is an exponential rise in prices and tends to occur not when countries print too much money; but with a collapse in the real underlying economy. The printing of money is a desperate effort to maintain stability and prevent production from coming to a halt.  That’s what happened in post-WWI Germany and during the 2000s when Mugabe was in Zimbabwe. On the other hand, the U.S. economy remained productive during the period of the Great Recession and only saw very modest increases in inflation.

 

Source:https://www.thebalance.com

 

Key takeaways:

• Prices did rise modestly in the low-interest rate environment that followed the Great Recession, but not nearly enough to be considered hyperinflation.
• Hyperinflation is an exponential rise in prices and is generally associated with a collapse in the underlying economy.
• During the Great Recession banks still had bad loans and toxic assets on their balance sheets as a result of the housing bubble and its aftershocks.
• While the central bank did increase the money supply sharply, banks used these funds to shore up their balance sheets and buffer toxic assets, rather than create new loans

Reference:

Why didn’t Quantitative Easing lead to hyperinflation? Adam Hayes, Mar 24, 2020

(https://www.investopedia.com)