QE2 – A prescription for hyperinflation?

After the Fed recently announced their plans to begin a new $600B phase of quantitive easing, or QE2 as it is commonly being referred to, a lot of people have voiced up their viewpoints.

As some of my readers may not know what quantitative easing is, let me give a basic description of it.  QE is a way for our central bank, the Fed, to increase the supply of money in the economy.  They do this by purchasing government debt with money that they create out of thin air.  For example, they call their buddies over at Goldman Sachs and say they want to purchase $600B of US Treasuries.  Goldman puts the treasuries in the Fed’s account.  Someone at the Fed then sits down at a computer, makes a banking entry to create $600B in their bank account and then transfers that amount to Goldman’s bank.

Once Goldman’s bank receives this “new deposit”, it becomes part of their bank’s reserves which they can then lend out up to 10x that amount – essentially, this new deposit could create $6,000,000,000,000 ($6 trillion) of new debt/money in the economy.

Based on a report from the Federal Reserve in May of 2010, there is approximately $940B of currency (paper money) and coins currently in circulation.  The Fed also reports that approximately 2/3rds of that amount is physically outside of the US.  So based on my calculations, that means there is only $310B of currency and coins in the US.  Therefore, if Goldman Sachs decided to withdraw this newly created money, they would only be able to withdraw half of it and that is assuming that all dollars and coins were removed from all pockets, wallets, purses, home safes, cash registers and bank vaults.  Okay, this would never happen, but I thought it was an interesting example to illustrate just how much $600B actually is.

After I started really looking at this, I became more interested, so I went to the Federal Reserves website and downloaded the actual monetary stats for the past 25 years.  As most of you know me as a business intelligence consultant, it is probably no surprise to you that I dumped this raw data into Microsoft Excel and began analyzing and graphing the data.

Following is a graph of the Monetary Base (paper money and coins in circulation plus the electronic money the Fed creates with their computers, as described above).  The graph shows a nice steady increase of the monetary base from October 1985 through September of 2008.

Source: Board of Governors of the Federal Reserve System

However, in October 2008, you see explosive growth in the monetary base until it began to ease down a bit in October 2010.  What caused this you might ask?  QE1, or the first round of quantitative easing.  This is where the Fed went out and started buying up approximately $1.7 trillion of toxic debts to “help the economy.”  The idea was that when Goldman Sachs and the other financial institutions deposited their $1.7 trillion of proceeds from the asset sales into their banks, this would create $1.7 trillion on new bank reserves which the US banks could then use to lend out (remember at up to 10x those reserves) to businesses to help revive the economy.

Did it work?  Did the effort of quantitative easing make money easy for America’s businesses?  Well, I think the following graph will answer that question better than I can.  This graph shows M2, which is a broader view of “money.”  M2 includes paper money & coins in circulation, but also includes electronic money in checking accounts and other “demand accounts.”

Source: Board of Governors of the Federal Reserve System

Hum…  I was expecting for a spike in the M2 graph at the same point in time the MB spiked.  Not only do we not see a spike, you can actually see the rate of growth of M2 actually slowed down around October 2008.  Okay, so the Fed thought they would “stimulate” the economy with QE1, but it actually slowed the growth of M2 down.  Some of you might be wondering, “how the heck can that happen?”  Glad you asked.  The following graph answers that question.

Source: Board of Governors of the Federal Reserve System

As I mentioned earlier, the banks can basically lend out 10x the amount they hold in reserves.  Therefore, the M2 Multiplier is a gauge to see how aggressively the banks are lending.  Back in October of 1985, M2 was 12 times larger than MB.  The graph clearly shows us that the following decade the multiplier drops to around 8, which it stays at for the next decade.

In 2005 it begins to rise a bit for 2 years (possibly the rise of lending before the real estate crash), but then what the heck happened in October 2010?  The multiplier basically gets cut in half!  This is where the banks thanked the Fed for QE1, but chose to hold that money in excess reserves, rather than lending it out to America’s businesses.

So what will the graphs look like after QE2?  Obviously there will be a spike in the Monetary Base (MB).  It will jump from its current value of $1.987 trillion to approximately $2.6 trillion.  That is a growth rate of 30% in one year!

The bigger question is, “What will happen to M2?”  At this point, nobody knows.  Will the banks hoard the money, like in QE1?  Will the banks start lending again to keep the M2 Multiplier at 4.4?  If they do, this will expand M2 by $2.6 trillion.

There is a growing group of people who think the Fed is sending the US economy down the path of hyperinflation.  If the banks hoard the money, then I don’t really see that happening.  But, what will happen when the banks remember that they make more money by lending more money?

What if over the next several years they move that M2 Multiplier back up to 8.  Based on a MB of $2.6 trillion, that would make M2 $20.8 trillion.  Considering M2 is currently only sitting at $8.7 trillion.  That would be a 240% increase in M2!

Inflation is simply more money chasing the same amount of products.  This causes the prices of products to increase with the increased money supply.  At 30% increase in the money supply would undoubtably create price inflation.  A 240% increase in the money supply wouldn’t create inflation, it would create hyperinflation.

In a report published by the Federal Reserve Bank of St. Louis in October 2010, the following was said about the potential effects of QE2:

Growth of the M1 and M2 monetary aggregates accelerated sharply after the Fed began QE in September 2008, but then declined as banks increased their holdings of excess reserves. If banks decide to hold most or all of QE2 as excess reserves, there would be no corresponding increase in the money supply and, consequently, no increase in inflation.

That’s a big “if”.  I personally think the Fed is playing with fire.  What do you guys think?  I would love to read your comments below.

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