Inflation arises from an environment in which the number of dollars and credits exceeds the available goods and services. In its simplest form, there are two ways to fight inflation, limit consumption or expand supply. The Fed uses monetary tools in an attempt to increase or decrease demand to close the gap between supply and demand. The biggest question right now is –Does Federal Reserve policy have a tightening effect?
QE versus QT
I often hear people talk about the money being printed by the Fed to prop up the stock market, flooding the economy with dollars, and investors/consumers speculating or spending like drunken sailors. These comments are quite misleading and do not help explain the mechanisms of QE. The Fed is not inherently injecting money into the economy. Instead, they createpotentialto ensure these dollars enter the economy by creating bank loans.
So how does the Federal Reserve “create” money? Simply put, the Fed creates dollars by exchanging cash for bonds. Treasury bonds and other types of fixed-income instruments are held on the Federal Reserve's balance sheet, and cash is placed on the balance sheets of major banks. The bonds leave the banks' balance sheets via an electronic entry and cash is credited. The idea is that the more dollars and liquidity a bank has on board, the more it will try to lend those dollars in the form of loans.
If the bank does not do this, it risks diluting the return on its assets. As long as there are creditworthy borrowers, in terms of loan demand, there is a bank on the other side willing to put those dollars into the economy.
Banks compete to create loans, but the biggest constraint for banks is that they must remain profitable. They can't produce too many risky loans i.e. 2008 if they want to stay in business. As loans are reproduced, a stream of money growth is injected into the system and dollars are 'born'. The Fed does not directly increase the number of dollars in the system, but instead creates the opportunity for those dollars to enter the economy.
Essentially, the bank acts as a “midwife” as it brings these dollars to life. The key takeaway here is that money creation starts at the Fed, but loan creation is the main driver of those dollars entering the system. Of course, central banks can certainly influence loan demand by lowering the fed funds rate or through open market operations.
But the challenge is that if people are unwilling to borrow, lowering interest rates won't necessarily help. An example of this is Japan's thirty-plus years of large-scale asset purchase programs such as Quantitative Easing (QE). For three decades, Japan has seen no real growth because Japanese consumers have essentially refused to borrow. To be fair, this is a multi-factor equation, and there are other factors contributing to Japan's slow growth – such as an aging population and poor private market competition due to poor policy decisions – but the point stays.
So why didn't we see rapid inflation after the Great Financial Crisis of 2008? This was mainly because banks were limited in their lending at the time, as many were reeling from the 2008 insolvency and the declining money supply. The Fed felt it had to intervene and introduced quantitative easing (QE) to support it
banks and ensure that the money supply and reserves do not shrink further.
In 2020, we saw manic borrowing through the coronavirus stimulus relief programs as both corporations and small businesses borrowed out of fear, which can certainly cause inflationary effects (creation of dollars through loans). Later, we saw additional CARES (Coronavirus Aid, Relief, and Economic Security Act) stimulus checks of $1,200 per eligible adult sent directly to individuals. The Fed acted as a lender not only to financial intermediaries, but in this case also to the end consumer. This distinction is especially important because it bypasses the bank lending process and injects money directly into the economy through handouts, straight into the hands of consumers. Some argue that this had a more direct impact on the inflationary impact on the overall economy.
The Fed will deploy additional monetary policy tools, such as QE, which we have certainly seen in recent years. QE is being implemented on a much larger scale and is intended to influence long-term interest rates, where they will go to the open market and buy long-term government bonds, corporate bonds and asset-backed securities (ABS). The application is the same: the Fed builds up reserves and uses those reserves to buy securities in large quantities, removing these securities from the market and thereby affecting interest rates by lowering them (bond yields fall as prices rise), causing it becomes cheaper. for companies to borrow.
QT
Consider the Fed's balance sheet and the handful of government bonds on their books. As these government bonds mature, they are removed from the balance sheet (not reinvested). During a QT campaign, the US Treasury will issue new debt through the UST auction and then use these proceeds to pay the Fed. The money Fed
receives from the Treasury, the sales proceeds are then evaporated from the system - they disappear. Essentially, the dollars "die" out of the system through the Fed when this debt is repaid. From a supply and demand perspective, this would result in more U.S. Treasury bonds entering the market, which would lead to lower interest rates and higher interest rates (again, there is an inverse correlation between bond prices and interest rates).
We are in a phase where everyone wants cash, but cash and liquidity are slowly being sucked out of the system – assuming everything else remains the same.
If there is less cash available when everyone wants cash, many of these investors will sell their stocks and other assets to generate cash, resulting in lower stock and asset prices.
Reserves are eliminated at different rates, all set by the Fed, and this could theoretically limit the effect on bank lending. The opposite effect occurs when it becomes more expensive to borrow dollars. This was introduced to tighten expenditure or credit growth. The Fed's ultimate hope is to destroy demand and create more balance between supply and demand – to combat the current inflation problem.
The current credit environment
In the early parts of 2022, we found that two measures of inflation, personal consumption expenditures (PCE) and the consumer price index (CPI), were both still accelerating rapidly despite the Fed's efforts to destroy demand through recent interest rate increases. In August, we saw the US consumption-weighted average price of goods and services increase by 0.1% on a seasonally adjusted basis and by 8.3% over the past twelve months on a non-seasonally adjusted basis. The data show that households continue to borrow due to increases in nominal wage growth and historically high asset values. As mentioned earlier, this is especially important because we know that money is created when banks make loans – this new money flows through the economy and contributes to ever higher prices. Bank credit creation was high in 2021 and got off to a strong start in early 2022.
Conclusion
In nominal terms, spending continues to grow at a high pace, driven by wage and credit growth. This suggests that the Fed's policy may still be too accommodative, as the Fed has made clear that its main goal is to fight inflation. Interest rates are likely to remain too low as wage, credit and wealth growth remain strong, meaning the Fed may feel the need to push back more aggressively on market prices in an effort to tighten monetary policy. Being 100% risk-on/100% risk-off or making large one-sided bets is probably inappropriate, especially in the current environment with so much cash flow uncertainty.
