The Economist: The end of quantitative easing

The topic on everyone’s mind these days seems to be, “What will happen when the Federal Reserve ends quantitative easing?” Most of the people I talk to have a vague idea that it will result in higher interest rates and higher inflation, but no clue as to why.

It’s pretty simple, actually – just the old law of price determination at work. Every month the Department of the Treasury issues a mountain of debt in the form of Treasury bills, notes and bonds. Some of this is to refinance debt that is rolling over, and some of it is new debt to pay bills that aren’t covered by tax revenues. The latter finances the deficit.

When the supply of something goes up – all other things being equal – the law of price tells us that cost goes down. But remember, the interest rate isn’t the price of government debt. Rates move in the opposite direction from the price at which the security sells. With all of the new debt filtering into the market, we need new buyers to keep prices from falling and rates from rising.

For a while, with the world economy mired in serious recession, entities looking for safe investments provided the new buyers. Eventually though, they decided they had about enough of U.S. securities, so the Fed stepped in as the new buyer. The unusual part was not only the size of their monthly purchases ($85 billion in the first half of 2013), but also the fact they were buying longer-term debt rather than simple Treasury bills.

At first we might ask, “Why doesn’t the Fed keep up the purchases indefinitely? Low interest rates are good for the economy and they just print the money for the purchases, so they never run out.” There’s the pesky little problem of low interest rates hurting savers, but that isn’t most people’s main worry.

That’s where the inflation concern comes in. When the Fed purchases Treasury securities, the money goes into accounts at commercial banks. It seems no different from when you or I buy something.

But there is one huge difference. Our purchase simply moves money from one bank to another – the amount of money in circulation goes unchanged. The Fed’s purchase is with brand-new money. To oversimplify, think of them running a printing press in the basement to print new bills used for the transaction.

In normal times, the banks take the new money and lend it to business and consumers, allowing them to make more purchases. Back to the law of price, if demand increases and supply is unchanged, the price goes up. For a while businesses will increase production to meet higher demand, but that takes time and eventually they run into capital and labor constraints.

This time around, due to challenges from the recession, banks haven’t loaned much new money. But, at some point, they will decide it is safe to lend again; we can already see that beginning to happen. Before long, prices will inevitably rise.

Interest rates will already be increasing because the Fed is purchasing less Treasury debt. Given the amount of money the banks hold and the sizeable reduction in demand for Treasury debt, the fear is that we’ll see a surge in both rates and inflation. Once that happens, workers will demand higher wages, lenders will demand higher rates on investments and 1980s history could repeat itself.

This time, though, there are several differences that make me optimistic. The Fed can pay interest on the deposits banks hold with them, making that option more attractive than too many risky loans. The Fed also has a huge portfolio of debt that it can sell, which will push bond prices down. Of course that means rates will rise. But the Fed understands more than it did in the 1970s and 1980s what actions it needs to take.

There is no way we will avoid higher rates and higher inflation. But that isn’t necessarily bad, as long as it isn’t excessive. Let’s wish the Fed lots of luck and hope the new chair has nerves of steel and a deft hand.