To understand the latest move from the Federal Reserve in detail we have to be able to look at the cash flows involved in the transactions they are making and follow those flows through the various sectors of the economy that are influenced.
So somebody call James Brown; let’s break it down:
The Fed announced they’d be buying $40 billion of mortgage backed “agency” securities each month, and, instead of returning the profit from the income to the Treasury (as-is their law), they will re-invest the proceeds by purchasing more agency securities, or possibly long-term treasuries.
So what does that mean? Basically, when the Fed buys Treasuries or Agency securities, they create new dollar “reserves” to buy the asset from banks and institutional investors.
This creation of dollar “reserves” is what leads to all the shouts of “money printing” and “stimulus” from the news cycle. But the reality plays out much different.
Consider what happens in this transaction: The new dollars go to the seller of the asset, and the Fed gets the asset. So it’s important to note that net worth in the private sector is not changed. Imagine you were the seller of the asset to the Fed. You just sold an income (dividend) producing asset in exchange for dollars which pay no interest. The dollar value of your net worth is unchanged. In one sense, you are actually worse off than before, because you no longer have the income stream from the dividends!
Now let’s finish out the chain and watch the cash flows as they move: The interest income from the asset you sold now goes to the Fed, which takes it and purchases long-term Treasuries, and then they take the income from the Treasuries and (by-law) return it to the Treasury! All of that income is taken from the private sector and destroyed by being given back to the Treasury. The end result is that the direct transmission mechanism of Quantitative Easing is deflationary, not inflationary as traditional channels suggest.
What about the indirect results? Could those be inflationary?
As we said above, as the seller of the asset, you are now sitting on a pile of cash which is earning you nothing. So you have to go and re-invest those dollars someplace else! What are you going to invest in? Well, the Fed has already driven the interest from Treasuries to next to nothing. The income from Agency securities will go down because the Fed is buying $40 billion dollars worth per month. Most likely you are going to invest in High-Yield Corporate Bonds or Blue Chip Dividend Paying Stocks. Maybe, (if you call me), you’ll invest in rental property or , perhaps you’ll buy a REIT (Real Estate Investment Trust). Or perhaps you’re just going to go back and buy different agency securities at a (likely) lower yield.
So this is good for the stock market and corporate bonds, but that’s about it. It will also serve to lower interest rates on mortgages even further (as the Fed re-invests in long term treasuries), although they are so low already and the amounts small enough that the difference should be minimal. This is the goal of the Fed, and has been all along. They’re trying to stimulate housing demand through uber-low interest rates. So the treasury market will continue to do well and prices of those bonds will go higher and yields even lower. The hyperinflation you heard about on TV is nowhere in sight. In addition, the effect on the job market is somewhere between amorphous and not really much at all.
The one way this could be inflationary was if there was suddenly a big upturn in residential development and new mortgages. This would generate an increased amount of credit and expand the money supply. However, new mortgages and residential development are not just a function of low interest rates, but also supply and demand. Banks have severely curtailed the supply of loans because of all the bad mortgages on their books and are also requiring higher down payments, which people don’t have because their income is down because of unemployment, poor sales, etc. Demand from consumers is down for the very same reasons. So the idea that lower interest rates will increase the supply of loans in the economy and offset the deflationary effects of lower interest income in the economy is mistaken.
Overall, this is a double-edged sword but almost certainly more deflationary than inflationary, as the Fed continues to suck more and more interest income out of the economy. The results of the past episodes of “Quantitative Easing” as well as the Japanese experience (basically the same thing for 20+ years) has borne this out.