In memory of Dr. Andreas Höfert

QE to infinity?

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US Federal Reserve Chairman Ben Bernanke is less than upbeat. In his testimony to Congress, he declared: “growth is projected to be not much above the rate needed to absorb new entrants to the labor force, [so] the reduction in the unemployment rate seems likely to be frustratingly slow.” While Bernanke did not explicitly mention the possibility of further quantitative easing, many analysts foresee this happening if the US business cycle – and especially its labor market components – continues to weaken.

But how far can the Federal Reserve and other central banks go? Isn’t there a limit to quantitative easing? Commodities expert Jim Sinclair, one of my favorite bearish market commentators who – as is often the case – also happens to be a gold bug, has warned of “QE to infinity.” In his view, it is as certain as death and taxes.

For Sinclair, QE to infinity would mean another 17 trillion – that’s 17,000 billion – US dollars of quantitative easing. Seventeen trillion? According to the Congressional Budget Office’s worst-case scenario, the entire US public debt will amount to 17 trillion in two to five years. Which means that at some stage, the Federal Reserve could hold all US public debt. Is that even possible?

Yes, it is. Back in 2002, when he was only a board member at the Federal Reserve, Bernanke gave one of his most (in)famous speeches: “Deflation: Making sure ‘it’ doesn’t happen here.” In it, he listed all the measures the Federal Reserve could take to avoid deflation, including implementing ceilings on the interest rates of US Treasuries. Those ceilings would be enforced “by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields.”

But what would the consequences be of buying another 15 trillion dollars of US debt, to go along with the two trillion that the Federal Reserve already holds? This would increase the current US monetary base roughly sevenfold, making it 22 times larger than before the financial crisis of 2007–2008. An increase of 22 times might seem extraordinarily large. Then again, it is roughly equivalent to the increase which occurred in the 60 years between 1948 and 2008.

But wouldn’t this cause tremendous inflation, or even ultimately hyperinflation? It depends. We first need to acknowledge that the monetary base can affect prices via two routes, the money multiplier and the velocity of money, and both of these are currently blocked. The M1 money multiplier – the ratio between M1 and central bank money, M1 describes the amount of physical cash in circulation or held in checking accounts – fell by half during the financial crisis, from 1.6 to 0.8 – meaning basically that for each US dollar the Fed prints now, only 80 cents makes it to the public. The velocity of money, or the number of times money changes hands in a given period, also came down, dropping roughly one third from its peak in 2007 and still falling.

If we assume that the money multiplier stays where it is and the velocity of money continues its trend for another five years – both reflecting deflationary tendencies at work – then a 22-fold expansion of the monetary base would create the potential for inflation to push prices up approximately 10 to 15 times.

Would this qualify as hyperinflation? Here again it depends. A tenfold increase of prices over the course of 20 years corresponds to average inflation rates of 10–15% per year, which is high inflation but not yet hyperinflation. The same tenfold increase within five years would mean an average inflation rate of 60% per year, which already comes quite close to hyperinflation.

This bit of arithmetic shows that “QE to infinity” is ultimately implausible unless you assume that the Federal Reserve becomes completely irresponsible – and it should also curb the enthusiasm of market participants cheering every hint of a new batch of QE.