By several metrics, the Bank of Japan (BOJ) has the most aggressive quantitative easing (QE) program of all the mainstream central banks. Last week the BOJ upped the ante again, this time to a rate of 80 trillion yen per year of money creation. For context, that is tantamount to each year printing 17% of all of the income earned by households and firms, which is about triple the speed of the Federal Reserve’s QE 3 operation. So why isn’t it “working?” After all, the BOJ felt compelled to increase their already-enormous program, which is essentially an admission that their goal of 2% inflation is still frustratingly elusive. Shouldn’t there be a point at which some astronomical level of QE must be inflationary?
My view is rooted in the semantics of what constitutes QE. QE is money printing, we all know that, but the money is not just given away for free by the central banks. Newly created money is exchanged for something of value, i.e. central banks need to purchase an asset to back every new unit of currency they create. This process is an anti-inflationary safety mechanism to prevent monetary policy from engaging in outright currency debasement, and could easily be mandated by decorum as much as by the various central banking legal frameworks. Tweaking the usual analogy, if dollars are dropped into an economy from a helicopter, in practice the pilot would be hoovering up IOUs as fast as the dollars fly out. There is no wealth transfer from the helicopter to the economy. We know intuitively that over time there is no way to create real wealth with fiat money printing, but contemporary QE does not create even an illusion of wealth transfer. In essence, quantitative easing still requires that an economy as a whole agree to forgo future consumption in exchange for consumption today.
Because QE doesn’t allow the economy to just spend new money with “no obligation,” the inflation engendering power of QE depends primarily on lending. QE results in the substitution of cash for longer/riskier assets on the balance sheets of domestic banks, in aggregate, which provides increased lending capacity to the economy as a whole. For banking systems that are limited by reserve requirements, the newly created excess reserves boost capacity. For banking systems that are limited by total system capital, existing capital/risk capacity is freed up to support new lending because riskier assets are transferred from the economy’s banks to the central bank. If the increased lending capacity actually leads to new loans (“credit growth”), the multiplicative effect on bank deposits should be inflationary. In fact, it seems to me that this is the primary channel by which QE described above could create consumer price inflation. However, credit growth remains uninspiring, regardless of whether it is because banks are not lending or borrowers are not borrowing. QE has led the horses to water, but cannot make them drink. I would suggest that in isolation, even ludicrously large QE programs may not succeed in generating inflation.*
To me, this rigmarole sounds like an awfully convoluted way to achieve a simple goal. What if we dispense with the notion that a central bank’s balance sheet must acquire a new asset in exchange for every new unit of printed currency? If the central bank really did gift the cash into the economy (say by giving it annually in modest increments to the government and allowing a semi-permanent tax cut), I suspect the result would be far more inflationary. By extension, the amount of money creation necessary would likely be far less than the totals we see now. For situations such as Japan, where policymakers seem desperate to generate inflation and where the central bank enjoys a closer relationship to the political apparatus, perhaps such a scenario is not so farfetched. There are less overt methods of achieving the same thing, such as canceling a portion of government debt already held at the central bank, or committing to roll a certain portion at perpetuity. I suspect each printed yen would go a lot further if it came with no strings attached. Obviously such policies appear to penalize savers and reward profligacy, but inflation does that, not the policy. Inflation is what they say they want.
*If governments ramp up deficits funded by new borrowing, this would still count as expansion of lending and is now apparently critical to the efficacy of contemporary QE. See Help Wanted.