Will the Fed's Quantitative Easing Lead to High Inflation?

nprecedented stimulus policies have been taken by the United States in response to the Covid-19 pandemic and these have led to a dramatic expansion of the Federal Reserve's balance sheet and the fiscal deficit. One big concern is whether these measures and the restarting of the economy will lead to high inflation. Since the financial crisis in 2008, four rounds of Quantitative Easing (QE) have been initiated by the Federal Reserve, without creating much higher M2 growth rate or high inflation. But the unlimited QE policy initiated by the Federal Reserve this time has pushed the year-on-year M2 growth rate to a new historic high. Why is it different this time? Will high M2 growth result in high inflation? Will there be other factors that contribute to high inflation in the future?

Causes of High M2 Growth

Base currency refers to the total cash held by the public and circulating outside the banking system as well as the reserves held by the central bank against deposits in the commercial banking system. It is also called high-powered money, since it has the capacity to enlarge or shrink total currency substantially. It is provided by the central bank and released when the central bank's balance sheet is expanded. Through the money multiplier, base currency can be expanded to broad money (M2), so the enlargement capacity of base currency is determined by the money multiplier.

Since the 2008 financial crisis, the Federal Reserve has launched four rounds of QE, enlarging the Fed's balance sheet by 4.6 times from US$0.97 trillion in September 2008 to US$4.46 trillion at the end of 2014. However, over the same period the average year-on-year CPI growth was only 1.65%, showing no high inflation from this unlimited QE. To cope with the economic shock of Covid-19, the Federal Reserve's balance sheet

was expanded once more in 2020, with the total of assets and liabilities increasing from US$4.13 trillion in February to US$7.09 trillion in June. Nevertheless, unlike in 2008, the year-on-year M2 growth rate during this period of QE reached a record new high in May at 23.14%, the highest level since 1960. In comparison, the highest year-on-year M2 growth rate was only about 10% during the QE of 2008. Why was it different this time?

In 2009, the year-on-year growth rate of US base currency broke through 110% at its peak, while the corresponding year-on-year M2 growth rate was only around 10%. However, in May 2020, the yearon-year growth rate of US base currency approached 60%, while the corresponding year-on-year M2 growth rate exceeded 20% (Figure 1). This huge contrast is mainly a result of the changes in the money multiplier (Figure 2). According to the exogenous determination theory of money multiplier (Milton Friedman, Anna Schwartz, and Jerry Jordan), of which M2 is broad money supply, B is base currency, and M2 is the money multiplier between M2 and B. Obviously, while M2 drops rapidly, the rapid enlargement of base currency will not lead to high M2 growth rate. From 2008 to 2014, M2 fell rapidly; it fell from 9.12 in August 2008 to 2.88 by the end of 2014. This is the reason why the last round of QE did not lead to a high M2 growth rate. However, although M2, the money multiplier, declined in 2020, the drop was limited, not enough to offset the rapid enlargement of base currency and thereby resulting in relatively high M2 growth subsequently.

In future, there is still room for a slight drop in the money multiplier. According to money multiplier theory, the three main variables affecting the money multiplier are: the statutory reserve ratio, the excess reserve rate, and the currency ratio. All these three variables are negatively correlative with money multiplier. To be specific: (1) The statutory reserve ratio is not a major factor affecting the US money multiplier. In fact, the US statutory reserve ratio has always been relatively low; it was 0.6% in 2008, followed by a gradual rise to 1.6% at its peak before declining to 0 in March 2020. (2) The excess reserve ratio is also a major factor affecting the US money multiplier. In early 2008, the US excess reserve ratio was less than 1%. However, during the successive rounds of QE

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initiated by the Federal Reserve, commercial banks did not allocate all base currency to the real economy but instead kept a large quantity of funds in accounts with the central bank. As a result, the US excess reserve ratio approached 24% by late 2014. This was the major reason why the US money multiplier dropped in the last round of QE. From 2020, the US excess reserve ratio rose rapidly again from 11.3% in February to 21.1% in May, indicating the growing reluctance to lend among commercial banks. (3) The currency-deposit ratio also has an impact on the money multiplier. It is defined as the ratio between currency in circulation and current deposits at commercial banks. In the last round of QE, the US currency-deposit ratio dropped markedly from 2.4 in August 2008 to 1 by the end of 2014, supporting the money multiplier to a certain extent. Since the onset of the Covid-19 pandemic, the US currency-deposit ratio has fallen again, dropping from 1.1 in February to 0.8 in May 2020. This might be affected by the large quantity of relief payments from the

deal of resistance to a sharp fall in the currency-deposit ratio in the short term. Therefore, if the Federal Reserve's balance sheet continues to expand, the money multiplier may fall, but it is unlikely to fall to the same extent as in 2008.

Changes in Currency Supply

According to the Fisher Equation, MV=PT, of which M represents the amount of currency in circulation, V refers to the speed of currency circulation, P is the general price level, and T means the transaction volume of goods and services. V is determined by social customs, personal habits, the level of technological development, and population density. T changes little in times of full employment. Therefore, V and T are relatively stable in the short term and may be regarded as constants. However, in Friedman's demand function for money, V is no longer regarded as a fixed constant, but rather as a stable function of such variables as the rate of return for financial assets and the expected price fluctuation rate. It is deemed by those holding the quantity theory of currency that changes in currency supply play a fundamentally decisive role in changes of price levels, while inflation means continuous and universe growth of price. Therefore, too much growth of currency supply is the source of inflation. Over the three decades from 1960 to 1990, the speed of US currency circulation was indeed relatively low between about 1.66 and 1.86. After the 1990s, however, the speed of currency circulation began increasing before reversing course: it reached 2.2 at its peak in 1997 and then fell to 1.37 in the first quarter of 2020. Additionally, the speed of currency circulation in recent years has been unsteady (Figure 3). As a result, the speed changes of currency

circulation should be considered while discussing the transmission process from M2 to nominal output.

The continuous reduction in US currency circulation is mainly affected by the following factors: First, the rise of deposit rates. Measured by the proportion of personal deposits in disposable income, the average US savings rate was 4.68% in 2000-2008, and that rose to 7.21% in 2009-2019 before reaching a peak of 32.2% in April 2020. The second factor was the change in the industrial structure. The turnover rate of capital varies in different industrial sectors. The turnover rate in sectors such as the financial industry, real estate, public utilities and information communication is normally low with a relative low speed of currency circulation, but the share of these sectors' increment in GDP has been rising continuously. The third factor is the low interest rates and expectations for low levels of inflation. After the 2008 financial crisis, interest rates and inflation were much lower than before the crisis. Low interest rates and low inflation expectations led to a lower speed of currency circulation.

Furthermore, history shows that there is no stable relation between M2 and inflation. In the US, for example (See Figure 4), it can be seen that during the three periods of high inflation in 1975, 1980, and 1991, the growth rate of M2 was low. Compared with other countries, there was no positive correlation between the M2 growth rate and inflation. For example, the year-on-year M2 growth rates of Japan and Switzerland were 2.45% and 2.71%, respectively in 2019, while their year-on-year CPI growth rate were 0.49% and 0.36% respectively.

Outlook for US Inflation

From the perspective of global trends, developed countries are stuck in low inflation. Since the 1990s, the inflation rate in developed countries has dropped remarkably, with high inflation seldom appearing. The main reasons are as follows: First, economic globalization has optimized the configuration of factor inputs and reduced prices of goods and services. Second, technological development has driven down prices of goods and services while restraining high inflation. Third, an aging population has reduced consumption and investment, leading to lack of demand. Fourth, with a growing income disparity between rich and poor, the marginal propensity to consume (MPC) of lowincome groups is higher while their actual income growth is slow. Fifth, excess production capacity and bulk commodity prices remain at low levels, thus holding back inflation.

Low interest rates and low inflation expectations led to a lower speed of currency circulation

During the pandemic, deflation will still be the main trend in the US. The pandemic has disrupted output and normal life. This has hit supply and demand. The US CPI will fall in the short term and deflationary pressure will persist. In the years before 2019, the US core CPI remained above 2%. With the spread of the pandemic in the US and the "stay-at-home" orders, core CPI fell rapidly. In May, the yearon-year core CPI increase dropped to 1.2%. From April to June 2020, the unemployment rate in the US remained above 10%, with lowincome groups depending on the government for relief. Subsequently, some government relief measures expired at the end of July, and a new relief program has been stalled by political division. It is unclear whether the economy will restart again and allow more of the unemployed to find work. On the whole, before the pandemic is effectively controlled, US consumption will be constrained, while consumption capacity will deteriorate. Therefore, while the pandemic remains uncontrolled, deflation will be the main pressure in the US.

After the pandemic, with the US economy recovering, prices of commodities may show a shift from deflation to inflation, but the possibility of high inflation is relatively low. Since debt pressure is huge, the proportion of zombie enterprises is rising, the unemployment rate is stubbornly high, while the disparity between rich and poor continues to grow, and problems with an aging population remain. This will lead to a situation where the supply side cannot recover quickly to pre-pandemic levels and core inflation may decline. Even so, the huge quantity of currency in the financial system will remain a long-term peril, which will increase the instability and vulnerability of the financial system while boosting financial asset bubbles.