What is Quantitative Easing(QE)? Does QE cause inflation?

Inflation—why now and not post-2008? What is the new normal? complex narrative simplified

Quantitative Easing
“Cash is King” – When the king disappears, the financial markets will cease to function causing asset prices to collapse.

QE: During the crisis, central banks steps in and buy assets from Investors, and the proceeds from the sale become a customer deposit at the investor's bank. QE effectively increases liquidity in the banking system/market to kick-start the economy again.

Does QE cause inflation?

The loan-to-deposit ratio decreases when the customer deposits increase in the banking system. As that liquidity cushion expands, banks have a greater incentive to lend. Cheaper and more abundant credit then encourages more spending and investment in the economy.

But banks don’t have to lend more. Inflation stays flat when lending does not increase.

Inflation—why now and not post-2008?

The answer is still a work in progress, remember Fed chair Powell insisting that inflation was “transitory” until he suddenly retired the word recently?

The prevailing hypothesis articulated by Benn Steil and Benjamin Della Rocca is that -

During the great financial crisis in 2008, banks’ lending stayed flat and did not increase in line with customer deposits and reserves, especially in the US. Banks were focused on strengthening capital and liquidity to navigate the crisis.

During the COVID-19 recession, banks had a different problem. Customer deposits and reserves ballooned due to the lockdown.

Unlike 2008, US banks behaved differently in 2022, around $1.2t in loans were made in 2022, a level around three times higher than that of recent years.

Additionally, the Ukraine war has stoked inflation in commodity prices. The productivity growth in China from 2008 to 2015 potentially offset the inflationary impact after the great financial crisis. However, the “zero covid” policy in China during pandemic has the added fuel to the fire this time around.

What is the new normal?

That is the “Trillion dollars” question, one thing is for certain, it will never be the 2% inflation target that prevailed pre-COVID.

what do you think?

To be continued...

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Image credit: Benn Steil and Benjamin Della Rocca.

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