Inflation is upon us as evidenced by rising fuel and food prices, along with almost everything from clothing, to housing, to new vehicles. Most economists point to this round of inflation as owing to ultra-low interest rates coupled with low unemployment thereby providing strong demand. The supply chain, still recovering from Covid, cannot rise up fast enough to meet this surge in demand. Rising interest rates are surely the cure, but what role does quantitative easing (or quantitative tightening) have in this situation?
Textbook Terminology: Most investors understand the marketplace for those particular products or services that they seek to invest in. But what about the market for money? In a capitalist society, virtually all economic activity begins with some form of investment. To bring about this investment, businessmen must often go into the money markets to obtain the capital necessary to bring about economic activity. The cost of capital is usually viewed in terms of interest rates or rates of return for capital that is retained in an organization and not borrowed. For larger organizations, all assets have some form of capital cost as this must be considered when comparing which avenue the management chooses to create business activity. For example, the cost of building a new factory might be best served by borrowing long term, or obtaining mortgages. However, the cost of increasing business inventory might be better served with the usage of cash and short-term securities that have a lower cost of capital.
The Money Market: In Modern Monetary Theory, interest rates will fluctuate with changes in the imbalances between borrowers and lenders. The lenders can be viewed as the supply side and the borrowers represent the demand. If there are fewer lenders with available funds for lending, but the same or an increasing number of borrowers, interest rates will rise until more lenders are able to enter the marketplace. The rising rates are what attracts more lenders to the supply side. On the other hand, if there are more lenders than borrowers, interest rates will decline thereby attracting more borrowers to the market place. From this standpoint, it’s a very simple market to understand. Then how could the Federal Reserve impact this market?
Federal Reserve Raises/Lowers Rates: The Federal Reserve’s role is to act as a lender of last resort to banks who need to borrow more funds in order to have money to lend into the working parts of the economy. When the Fed raises interest rates, this applies to Fed Funds rates to lending institutions only. The increased rates will be passed along eventually to consumer level borrowers as markets and regulations permit, but again, this will depend upon that imbalance between lenders available to lend and borrowers needing to borrow. It should be noted here that banks are not all alike—some are in better financial shape than others. Therefore, those banks that have to borrow more to stay solvent, are less likely to loan more money to the commercial level of the economy. The opposite is true for banks that need to borrow less money from the Fed.
Quantitative Easing/Tightening: This terminology rose to the forefront during the financial crisis of 2007/2008. It simply refers to increasing or decreasing the supply of money to the economy. Through the ordinary course of economic activity that includes population growth, it is not surprising to see some form of increase to the money supply over time. During the financial crisis, interest rate reductions alone helped, but did not render the requisite stimulus needed to spur the economy. The interest rate reductions were thereby supplemented by quantitative easing that involved the Federal Reserve buying U.S. Government bonds. The bonds were largely bought from the Treasury, or from banks and other lenders who use government bonds to hold money in reserve. With the Fed holding the bonds, it could be viewed as the government loaning money to itself, with the actual cash placed generally into the investment sector. But the amazing trick with this is that the bonds will eventually expire worthless if the Fed continues to hold them to maturity. The Treasury will not need to redeem those bonds as it would be tantamount to the government paying itself back for borrowing from itself. However, the consequence remains the same, as the money supply will still be increased and will remain increased until quantitative tightening becomes applicable.
The Impact of Increased Money Supply: With QE, the money supply has been increased, and more money has been placed primarily into the hands of lenders. This has the same impact to lenders as lowering the Fed Funds rates as it serves to improve the existing imbalance of borrowers over lenders. It becomes an important consideration during economic crises as it can help boost the economy. Further, it takes the Treasury (and the U.S. Congress) off the hook as huge fiscal deficits are swallowed up by the central bank (currently to the tune of over $9 trillion!). But there must be some consequences somewhere, and there are. The overwhelming amount of QE has, over time, swelled the supply of money to the point that money has become very, very cheap. Sooner or later, continued cheap money in the money markets brings more feckless borrowers into the picture along with those who would be worthy borrowers but have misfortune in money management. It also breeds irresponsible fiscal policy on the part of the U.S. Congress and Administration who seek to supply political candy to their supporters without increasing tax revenues. In the long run, sooner or later, the result could be inflation.
Conclusions: In the final analysis, Modern Monetary Theory seeks to control the number of borrowers in the money markets. The aforementioned tools used are designed to draw borrowers in by creating more resource for lenders and therefore lower interest rates.
Sources: Richard Celley contributed to the blog.