When The Fed Prints Money, What Impact Does It Have On You?
The Federal Reserve, the United States central bank, has “printed” more than $2 trillion since the global economic crisis began in 2008. This has more than tripled the size of its balance sheet. Before this spree of paper money creation began, the Fed held $950 billion in assets; now it holds nearly $3 trillion. Why did they do this and what impact has it had on you, the general public?
They did it to prevent the global credit bubble that had been forming for decades from completely imploding. It is probable that the global economy would have collapsed into a New Great Depression had the Fed not printed so much money. Of course, we cannot know what would have happened for sure. Nevertheless, it is clear that the Fed’s actions supported the economy in three crucial ways.
First, it allowed the US government to finance $4 trillion of budget deficits (over three years) at extremely low interest rates. How did that work? The Fed created $2 trillion from thin air and used it to buy government bonds and other debt instruments (mostly mortgage-backed securities) from the market. The people from whom they bought the bonds then had $2 trillion in cash. Some of that cash was invested in the new Treasury bonds the government had to sell each month to finance its deficit. So, by directly buying government bonds and by injecting cash into the market that other people used to buy government bonds, the Fed made it much easier for the government to spend $4 trillion more than it took in as tax revenues. That government spending kept the economy from collapsing. (To understand how, review Economic Forecasting, 101, posted February 15, 2012.)
Next, that “injection” of $2 trillion of new money meant that there was a lot of money sloshing around in the financial markets. Some of that new money was invested in bonds, which pushed up the price of those bonds. When bond prices rise, their yields (or the interest rate the bonds pay) fall. Therefore, the creation of paper money by the Fed pushed interest rates lower. Consequently, the cost of mortgages, car loans and other consumer credit all fell. Lower mortgage rates kept home prices from dropping even further than they have; and lower interest rates on consumer credit supported consumer spending (and therefore the GDP).
Finally, money printing pushed up the stock market. The Fed does not like to say that it is “printing” or creating new money. Instead, Fed officials use the term Quantitative Easing to describe their money creating activities. There have been two rounds of Quantitative Easing, QE 1 and QE 2. During both rounds, stock prices rose sharply. Higher stock prices make people richer (so long as they remain high, at least); and when people are richer they spend more money. That spending supports the economy and it creates jobs and it generates tax revenues, which reduce the government’s budget deficit.
So, what’s not to like? Paper money creation allows the government to spend more, it keeps interest rates low and it makes stock prices high. It sounds too good to be true. And, it is. There are negative consequences (both actual and potential consequences) that I have not yet mentioned. The worst actual consequence so far has been a sharp increase in food and gasoline prices.
It has been known for centuries that printing money creates inflation. There are different kinds of inflation, however. These can be grouped into three categories: CPI ex-food & energy, asset price inflation and commodity price inflation. Let’s consider each.
The most closely watched kind of inflation is Consumer Price Inflation (excluding food and energy) or core CPI as it is often called. This measures the price increases for the things consumers buy such as clothing, electrical goods and cars; but it excludes the price of food and energy because these are considered to be too volatile. During the 1970s, core CPI spiked as high as 13.6%. Since then it has fallen steadily and it now stands at only 2.2% compared with one year ago. The reason it has fallen is Globalization, which has resulted in a collapse in the cost of hiring workers in the manufacturing industry. Before, it was necessary to pay a blue collar worker in Michigan $200 per day to work in a car factory. Now cars can be built in India using $3 a day labor. This collapse in wage rates has had the benefit of holding down inflation in the US; however, it has produced undesirable consequences of its own (to be discussed some other time). So long as Globalization persists, there will continue to be downward pressure on wages and therefore little core inflation. Protectionism would cause US wages to rise, but it would cause a sharp spike in inflation.
The second category of inflation is asset price inflation, or, in other words, inflation in the price of stocks and bonds. As discussed above, Quantitative Easing did cause a significant increase in stock prices and bond prices. In fact, one of the Fed’s main goals in printing money was to create asset price inflation. In this they have been very successful.
The problem comes with the third category of inflation, commodity price inflation. Gasoline prices are not $4 per gallon due to supply and demand factors, but rather because too much money creation has pushed up oil prices. Even worse, from a global perspective, is the surge in food prices that has resulted from the Fed’s actions. During QE 2, global food prices soared 60%. This has done much more damage than simply driving up the price of milk and bread at the local grocery store. It has created a humanitarian disaster for the 2 billion people (29% of mankind) who live on less than $2 per day. Higher food prices played a leading role in igniting the Arab Spring, the political uprisings that overthrew three North African governments and threaten to overthrow several more governments across the Middle East. The ultimate outcome of those revolutions is still undecided. It has been said that revolutions devour their offspring. They have also been known to frequently devour their neighbors. Saudi Arabia is in that neighborhood. We can hope for a democratic outcome that works to everyone’s advantage. That outcome is by no means assured, however. A third round of Quantitative Easing would cause another spike in food prices and that could cause more hunger-inspired revolutions to erupt all around the developing world, with more destabilizing geopolitical consequences.
Those are the actual consequences of printing money. Hyperinflation is the worst potential consequence. So far, inflation remains low. However, paper money creation has a long and ignoble history. It has almost always ended in tragedy. The great American economist, Irving Fisher (1867 - 1947) put it this way, “Irredeemable paper money has almost invariably proved a curse to the country employing it.” Time will tell if it eventually proves to be a curse for the United States (and Europe and England and Japan and …).