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I am amazed at how many macroeconomic commentators promote the false notion that quantitative easing does not cause inflation by citing arcane explanations of the Fed's balance sheet, the difference between bank reserves and currency in circulation, the highly structured means by which the Fed conducts QE, or other means that obscure the clear objectives of this unorthodox monetary policy tactic with unnecessary complexity.
Let's take a moment to look back at why the Fed began “quantitative easing” in the first place.
In the fall of 2008, amid a near-constant string of dire economic trends in housing and the economy in general, and following the collapse of Bear Stearns and Lehman Brothers, the Fed finally had an “epiphany” and went beyond its usual policy tools to tackle the crisis head-on with an approach that was new to the American business world: quantitative easing (QE).
These two articles (click to enlarge) published at the start of the Federal Reserve’s QE1 paint a good picture of the situation:
Notice the atmosphere of crisis and desperation as Americans and people around the world with financial interests in the U.S. real estate market were genuinely panicking about the fate and integrity of the U.S. economy.
QE1 was a one-two punch that combined a zero percent interest rate policy (ZIRP) at the short end of the yield curve (the Fed's traditional federal funds rate policy) with ad hoc targeted yield control tactics at the long end through the Fed's direct participation in the mortgage market through its purchases of mortgage-backed securities (MBS) from Fannie Mae and Freddie Mac, the large government-sponsored enterprises (GSEs) that essentially formed the conforming mortgage lending market.
Importantly, the Fed's purchases of GSE MBS were not simply an effort to lower mortgage interest rates; by the fall of 2008 the mortgage market was essentially completely impaired, forcing the Fed to literally step in and replace the collapse in demand for these securities with its own artificial demand.
Losses from the collapse of subprime, near-prime, and even prime mortgages steadily increased, and the mortgage market ground to a halt as a large proportion of new or recent home buyers (those at the top end of the market) decided to jingle mail their keys to their lenders rather than suffer further setbacks from steadily falling home prices.
This was a devastating outcome for a highly financialized and extremely complex mortgage finance system; without the Federal Reserve's artificial purchases of MBS to reliquidate the mortgage lending market, home prices likely would have fallen by 40% to 50% nationwide, rather than the approximately 25% that the Federal Reserve successfully prevented.
So, more directly, the Fed's QE MBS policy has not only depressed mortgage interest rates, it has literally shaped the mortgage market since 2008 as the Fed transformed itself from a lender of last resort into, ultimately, a permanent player in mortgage finance.
Throughout 2010-2011 it was becoming clear (at least to me here, here, here and here) that QE was here to stay, a fact that would leave an indelible and fundamental mark on the economic landscape as highly financialized debt markets adapted to the Fed's continued participation and this falsehood became more and more ingrained in the dynamics of the system.
In fact, it has recently been estimated that even today roughly 30% of the entire U.S. mortgage market is directly financed by the Federal Reserve.This is an astonishing fact, but it is made even more alarming by the realization that the Fed's quantitative easing covers not only MBS purchases but also Treasury purchases, thus helping to artificially finance federal debt as well as mortgage financing.
This level of support was undertaken not simply to avoid “deflation” (the explicit goal of policy), but also to induce “reflation” in the markets and the bubbles that existed before the crisis, to ease the trauma felt more widely by businesses and households, and thereby to boost confidence in the system.
The results of these Fed actions are clear: the crisis steadily abated throughout the 2010s, confidence and sentiment gradually improved, stock prices enjoyed a significant and prolonged bull market, the housing market steadily reflated, and the overall economic outlook improved significantly.
However, it is clear that this “reflation” was actually a form of inflation, and that price levels of most asset classes (and probably consumer prices as well) would be much lower today if the Fed had not acted to “save” the economy from this remarkable struggle with deflation.
To complicate things further, by early 2020, the COVID-19 panic had circumvented the Fed’s initial attempts to withdraw some of this extraordinary support, placing the Fed squarely in the position of “savior” of the economic system, once again using ZIRP and QE to fight a major economic crisis.
But unlike 2008, the post-COVID economy was already awash with hot money, benefiting from more than a decade of historically accommodative monetary policy and the almost euphoric attitude that resulted from the continuing “wealth effect” in the stock and housing markets on businesses and households.
The Federal Reserve’s COVID-era zero interest rate policies and quantitative easing, along with massive federal fiscal measures (the PPP and various stimulus packages, also funded by the Fed’s Treasury QE), have served to literally transform previous economic “reflation” into pure “inflation” as economic participants caught up in the uncertainty of the pandemic began to violently resist throwing hot money at speculative absurdities like soaring bubble stocks, limitless cryptocurrencies, memestones, NFTs, SPACs, and a new wave of completely crazy real estate speculation.
Now, with inflation clearly “unstable” and literally no easy path out of this economic madness, the Fed and the economy as a whole will finally have to face the inevitable realities of these trying times.