QE appears to be on the way

Possibly pulling the trigger at the November meeting

Quantitative easing, or QE for short, is apparently the Fed’s most preferred method for lifting inflation and creating jobs.

First, a quick primer: QE is the purchases of government bonds designed to increase excess banking reserves at a time when conventional monetary policy has already brought short-term rates down to zero.

Like an individual who buys bonds, cash is transferred from the buyer to the seller, who places funds in his/her bank account.

Unlike an individual, the Fed creates new money to make the purchases, and when the newly-minted cash is deposited into a bank account, the banking system gets new reserves which can be lent out.

Problem – banks already hold $1 trillion in excess reserves that could be lent to consumers or small businesses but are being held safely at the Fed, earning a paltry 0.25%.

Fed’s last statement and minutes
Looking at the last Fed statement and taking in the many speeches given by various Fed officials in recent weeks, it’s becoming increasing clear that the Federal Reserve sees deflation as only a minor threat.  But it is concerned about a rate of inflation that it believes is too low.

Looking at comments in the last press release:

“Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.”

Let’s repeat: stating that it believes inflation will eventually rise to levels “consistent with its mandate” puts the central bank on the record as saying that deflation is not a major concern.

Possible, yes. Probable, no.

The Fed went on to say:

“The Committee will continue to monitor the economic outlook and financial developments and is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.”

Hence, the Fed was quite clear that it will do what’s needed to stimulate demand and raise the rate of inflation.

Based on recent speeches and greater detail offered by the minutes from the FOMC’s latest meeting, the Fed is worried that disinflation and falling inflation expectations will encourage consumers to delay purchases, which would hamper the economic recovery.

As it noted in the minutes, “With short-term nominal interest rates constrained by the zero bound, a decline in short-term inflation expectations increases short-term real interest rates (that is, the difference between nominal interest rates and expected inflation), thereby damping aggregate demand.

“Conversely, in such circumstances, an increase in inflation expectations lowers short-term real interest rates, stimulating the economy.”

A number of methods to facilitate such a strategy were discussed, but given the movement in the dollar, stocks and commodity prices, most expect a new round of QE.