Inflation, Deflation, and Quantitative Easing

Deflationists have had it easy for the past six months. Against real estate, stocks, commodities, and foreign currencies, the correction of the dollar has been robust from its all-time low a year ago. Even against old standards like gold and treasury bonds, it has held its own. As job losses and dire statistics mount, one wonders how much longer it will be before the prices of everyday goods suffer the deflationary squeeze. The only real threat to the dollar—the doubling of base money—has been nary a speed bump, and all this extra money now sitting idly in bank reserves is a laughable monument to the failure of policy makers to regulate the direction of the economy.

Yesterday, the fun came to a sudden end. Once again, fear and doubt have arisen around the fate of the dollar. The latest federal open market committee meeting voted in support of the purchase of $1.25T in bonds: $750B of mortgage backed securities, $300B of treasury bonds, and another $100B of GSE bonds from Fannie Mae and Freddie Mac. Quantitative easing has arrived.

When all is said and done, quantitative easing is a roundabout way for the Fed to issue loans straight from printing presses without fractional reserves or any deposit requirements. The Fed prints money to buy the $1.25T in securities listed above. That money enters the economy, and in exchange the Fed holds a legal obligation for that same amount to be paid back over the time the bond matures.

So quantitative easing is a variant of credit, which in and of itself offers no net threat to the value of the dollar. Credit is a temporary expansion of money that is undoes itself over the time the loan is paid back.

So, to the degree the bonds are good, any threat to the dollar is only temporary. However, if the Fed ends up with a mountain of toxic securities bought with newly printed money, defaults would be of no consequence to them. Unlike banks whose balance sheets suffer from defaults, the Fed loses nothing other than paper and printing ink. This would be pure cash expansion of the worst kind.

So—the market value of the securities the Fed is buying will determine how inflationary this process will be. If the Fed buys bonds at market value, then the economic correction will be slowed down but prices will still correct downward to fundamentals. If the Fed buys junk at full price, then Bernanke is dropping fresh money from helicopters—so grab your wheel barrow when it comes. The truth will lie somewhere in the middle.

Naturally, the dollar suffered with this news, and a small rally in stocks and other investments would not be surprising. But Japan has been doing this for years and the yen remains one of the stronger currencies. I’m not buying gold just yet.