Guest Post: Why QE Won't Create Inflation Quite As Expected

Tyler Durden's picture

Submitted by Charles Hugh-Smith of OfTwoMinds blog,

The Fed can create money but if it doesn't end up as household income it is "dead money."

In the consensus view, the Federal Reserve's unlimited quantitative easing (QE3) programs will do two things: 1) boost stocks and other "risk on" assets and 2) generate inflation. The two follow-on effects are related, of course; gold and other hard assets are rising in anticipation of higher inflation.

But all is not quite as it seems when it comes to the inflationary effect of creating money. I'm going to cover a lot of ground here so buckle up and grab your favorite stimulating beverage.

Let's use some examples to illustrate key features of the relationship between money creation and inflation. Let's say a central bank prints $1 trillion in cash currency, digs a big hole and buries it. Does that $1 trillion in new money cause inflation? No, because it never got into the hands of people who might trade it for goods and services in the real world.

Recall that the premise of monetary inflation is straightforward supply and demand: when money is abundant and goods are scarce, the price of goods rises as abundant demand (everybody has lots of cash or credit) meets limited supply (limited oil, gold, grain, etc.) in an open marketplace.

Let's say the Fed electronically creates $1 trillion and metaphorically buries it in some account where it sits as "dead money." It cannot trigger inflation because it isn't reaching the hands of people who might use it to buy scarce goods and services.

Let's also recall that money is destroyed, not just created, when assets fall in value and bad debt is written down. Consider a house purchased for $350,000 at the top of the real estate bubble with a $50,000 cash down payment and a $300,000 mortgage. The owner defaults and the house is sold for $150,000. The $50,000 down payment was cash; it was not “on paper.” It has not been transferred to someone else; it has vanished.

The same can be said of the $150,000 the bank lost on the mortgage. The bank’s cash reserves (capital) take a $150,000 hit. That was real money, too, and it wasn’t transferred to someone else; it disappeared. Thus $200,000 of real money has been destroyed.

To the degree that immense overhangs of bad debt are slowly being written off, money is being destroyed. If the Fed “prints” $500 billion a year, and write-downs erase $500 billion, the money supply hasn’t expanded at all.

The Fed bought $1.1 trillion in mortgage-backed securities as part of its earlier QE interventions in 2009-10. Notice that the $1.1 trillion has already fallen to $850 billion--a decline of $250 billion in just a few years. The loans were paid down, paid off or written off.



According to the Balance Sheet of Households (, home mortgages have declined from $10.3 trillion in 2009 to $9.7 trillion in 2012. Credit is being destroyed in the primary asset of the American household, their home: one-third have zero equity (underwater), millions more have insufficient equity to borrow against/extract, and millions more are not creditworthy enough to borrow more, even though they have equity in their house.

The decline in asset values has destroyed money and credit.

The general assumption is that the Fed buys dodgy MBS from banks which then take the money and dump it into the stock market, pushing stocks higher. This assumption fails to consider the weak balance sheets of banks, which will soon be required to post some collateral behind their trillions of dollars of outstanding derivatives.

The favored collateral is U.S. Treasury bonds, and so banks may be constrained by their need to build reserves against future writedowns. They may end up buying Treasuries as collateral rather than gambling in the equities market. The newly created money may end up as "dead money" in reserves, not cash propping up equities.

A number of indicators suggest money is not flowing into hands which might actually trade it for goods and services. Consider money velocity, courtesy of Chartist Friend from Pittsburgh:



The velocity of money buried in a hole is zero. The velocity of hoarded money is also zero. The velocity of credit that is never used (i.e. no money is actually borrowed and spent) is also zero. Money that is created but which has zero velocity cannot spark inflation.

If money were flowing into real-world households, we'd expect to see household incomes rise. Instead we see falling incomes. Here is the real (adjusted) income for the 45-54 year old age bracket, when lifetime earning tend to peak (courtesy of



Ouch. Income, Poverty and Health Insurance Coverage in the United States: 2011 According to the Census Bureau, "In 2011, real median household income was 8.1 percent lower than in 2007."

If there is net expansion of the base money supply, it isn't finding its way into household incomes where it could be spent on real goods and services.

As for the "wealth effect," it only affects the 5% who own enough equities to make a difference. That narrows the whole "wealth effect" to 7 million people out of 142 million workers.




Interestingly, the top 5% is the only demographic that is actively deleveraging, i.e. reducing debt rather than borrowing more:


Add all this up and here's what we get: money is not just being created by the Fed, it's being destroyed by declines in asset valuations and writedowns of impaired debt. Credit may be expanding but the top rung of households is paying down debt, not borrowing more, and the bottom 95% are unable to add much to their already staggering debt load.

Incomes are declining, providing a smaller base for both spending and borrowing. The top 5% may be experiencing a "wealth effect" as stocks soar but 7 million people cannot levitate the entire $15 trillion U.S. economy much while the incomes of the 137 million other workers are stagnant or down.

Money velocity is plummeting and banks are hoarding Treasuries as much-needed collateral.

It's difficult to see how these forces could generate inflation. There may be new money and credit being created, but very little of it is flowing to households whose spending in the real economy drives inflation.

New video program: The Federal Reserve: Flawed Premise, Mistaken Role:


Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
Stackers's picture

Mr.Smith, what happens when the international market dumps their trillions in "dollar reserves" into the market due to a lack of faith in the Federal Reserve Note due to excessively loose monetary policy ? Money volecity could explode in the blink of an eye if the world decides to dump it's dollar "reserves". And there is not a single thing the Fed could do to stop it.

Jean Valjean's picture

Bingo Stackers, you beat me to it.

Mr Lennon Hendrix's picture

Yet we don't need to go that far.  Keep it simple.  An increase in supply and a decrease in demand will find the equilibrium of the dollar's price (P*) lower.

This is inflation, as everything denominated in dollars will have increased in value vs the dollar.

Mark Carney's picture

FedEx made i nice delivery to my office today.....happy day if you catch my drift?? ;)

Newsboy's picture

Hunker-Down, It's what's for dinner.

El Viejo's picture

Smith sounds like a closet MMTer here.  Please elaborate Mr. Smith.

ParkAveFlasher's picture

Does FedEx make boat-to-boat deliveries?  Really don't want to pull 'er in, the fishing's really sweet right now.

--sent from my iPhone5

El Viejo's picture

Love the article BTW.  Have been crying "QE for the common man" for some time now, but they will not do it because of the moral hazzard.  Funny, they had no problem with moral hazzard when it was beneficial to them.

foodstampbarry's picture

--sent from imanidiot5.

Have you got your obama sign up on your front lawn yet?

El Viejo's picture

Mechanics trumps idiotology every time.

LULZBank's picture


Submitted by Charles Hugh-Smith of OfTwoMinds blog,

You guys missed the clue in the intro... of TWO minds i.e. confused.


- Sent from my stolen Nokia 3210

El Viejo's picture

Two ears = 3D hearing.

Two eyes  = 3D vision.

Man and Woman join and a Child is born.

As long as they don't face in totally opposite directions.


silverserfer's picture

 why ya hatin? wife leave you for someone who can still get it up?

Mr Lennon Hendrix's picture

New Playboy's College Party School Rankings is out??

Pam Anderson made her first cover on that issue.

Happy anniversary Pam!

Canadian Dirtlump's picture

It wasn't some of that maple syrup we had stolen from the strategic reserve last month was it? Probably shiny maples?


The inflation bomb may be delayed in the afoermentioned fashion but the crash will be the crash. This being said, would it be fair to say that banks can now gamble with the free fed money instead of what formerly would have been customers deposits? This must be why some banks are sending lower end retail banking customers to the wood shed. Motherfuckers.

walküre's picture

Good timing. The lakes are stacked with trout. It's a good day to go fishing with the dingy.

Canadian Dirtlump's picture

tomorrow I had planned to go on a canoe trip with some buffalos.

Mr.Bigfoot's picture

Fools! place your gold and silver in SECURE safe deposit boxes at your local bank. Boating is unsafe

JeffB's picture

Safe deposit boxes at your local bank aren't necessarily safe either, as some have learned to their dismay.


SafelyGraze's picture

".. the Fed buys dodgy MBS from banks which then take the money and dump it into the stock market .. [banks]  end up buying Treasuries."

which all looks like a super fun game

it's easy to play. according to wikipedia:

[keep away] One person stands in the center (and is called the consumer or citizen or wage-earner or home-owner) and the rest stand outside the circle.

A monetary authority outside the circle must then exchange the bank medium through the circle to another corporate person outside the circle with the goal being to prevent the natural person who is "it" from getting to the bank medium.

sessinpo's picture

And why inflationist have been wrong at this point (not really wrong but at least early) is the concept that not only is money created and destroyed, but that servicing debt is also the destruction on money. In other words, instead of that money serving a productive useful purpose of generating more wealth, it is being spent, destroyed on products and services already consumed.


After the trillions already created, and would be $16T + in US debt, $16T plus in US central banking funding around the world and that doesn't include any off book rehypothecation and printing, we should have had massive hyperinflation already. But we haven't. Reason why - all that money created isn't circulating throughout the economy which would be required for such inflation.

disabledvet's picture

Bingo yes...Poker no. The fact is the dollar weakens so yes, there is a repatriation "effect" of sorts. But the dollar is the world's reserve the inflationary effect is obviated. In the interests of intellectual integrity I was the biggest card carrying member of the Inflationista Class out there...and I was DEAD WRONG. Unlike the so called experts I do not argue with the this case the totality of the Treasury Complex...which is SCREAMING deflation. Given the amount of monies....meaning credit's hard for me to argue against "the Defense Spending Effect." And I don't. Our current Sec Def is a very good one...not that he needs me to say that...and should his boss win as is predicted will be a VERY powerful one indeed. Backing him up is no less than General Petraeus himself. As Colin Powell famously said "we have a lot of tools in our tool box."

blunderdog's picture

Folks here ain't tryin to hear 'bout no deflation. 

The "average" Hedge-poster wants hyperinflation tomorrow so their gold skyrockets in value, but that's just not going to be the way it happens.

Mr Lennon Hendrix's picture

Stack, although this is a fair point, we don't need to ask any "if/then" questions.  We can use strict math to show what will happen.

Mr Smith states coreectly that the Fed is increasing the supply of dollars while there is little demand for them.  This will decrease the value a la price (P*) of the dollar and that will increase all asets valued in dollar terms.  This is inflation in a nutshell.

Way to suck Mr Smith.

otto skorzeny's picture

gold will drop w/equity deflation they quickly soar.

ATM's picture

Perhaps in a static world but the world is not static.

I prefer to view the Feds actions as akin to placing a gasoline pump in ones basement and turning it on. The basement floods with gasoline but it takes a spark to ignite the coming explosion.

Same thing with inflation. We all know that printing will cause inflation but it is not a linear event. A triggering event sets it off. Have no idea what that will be or when that will be but I do know we are living in a house whose basement is being filled with gas. It's only a matter of time.

Mr Lennon Hendrix's picture

Flooding the basement with a standard of currency that holds no intrinsic value (the fiat dollar) is more like trying to swim in a shark tank.

WakeUpPeeeeeople's picture

Didn't the Bearded Ben claim a few months back that he can remove the printed money fron the economy in 15 min if he saw the need for it. 

BlandJoe24's picture

What's missing in your point is: 1. global context  2. the size and pace of credit destruction.  and 3. the obviousness of following the money

1. if you  only look at the US as an isolated unit, then yes, value of the dollar goes down.  but in a global context, the dollar is the "least weak".  other currencies will out control-P and out disintegrate the dollar, so on a relative basis (at least in the short-medium term) the dollar value will increase.


2.  the size and pace of multi trillion dollar credit destruction and price-discovery driven collapse is exponentially larger than printing can keep up with.   so again, on a relative basis the dollar will strengthen.  and not just markets will purposefully prevent a dollar collapse because the super-rich need a reserve currency to hold value through a collapse, and for at least a while, the dollar is their choice.


3.  where are the big banks and trans-nationals - who could do anything with their money and have actual control over monetary policy  - putting it? Yes, they are putting some in gold, but for the most part they are hoarding it in USD cash and cash equivalents (treasuries).  They are anticipating a rise in the value of cash.  They are anticipating deflation,  not inflation.  If/when deflation hits and the value of each dollar soars, guess who "wins" big?  Guess who will be able to suck up hard assets at pennies on the dollar?  Guess who will have even more power over those in debt to them?  Guess who's "king" in a deflation?

akak's picture

You may put faith in your unsubstantiated theories, but I will go with historical evidence, and history has yet to witness the first example of the exponentially-increasing IOUs of an exponentially-indebted person or entity becoming MORE valuable in direct proportion to that person or entity's bankruptcy.

BlandJoe24's picture

uh...except the history of the last....xxxx years?

IOU's, bankruptcies, and value involve (at least) two parties, so relativity matters.  as long as you have something left , bankrupt is more valuable (has more power and choice) than bankrupter.... so yes, the us is exponentially bankrupt, but the rest of the world is exponentially bankrupter

of course fiat currency is an illusion, and will eventually evaporate... but it's a mutually agreed upon illusion, and thus functions....and for now (and probably a while, even though "akak" says otherwise)... the players (ie the super-rich)  have chosen the US dollar as their reserve illusion, and they will defend it with all the force they can muster.  and sure, some of them will fall, but some will claw further up the pyramid of greed



akak's picture


uh ... except the history of the last ....xxxx years?

Well, I have no idea what parallel universe you have been inhabiting for the last xxxx years, but in the universe in which I live, the dollar has been steadily depreciating, as general prices and the cost of living continue to increase.  There has NEVER been one SINGLE year where this has not been the case under our purely fiat monetary system.

Deflationary flat-earthers: gotta love 'em!

sessinpo's picture

Of course prices tend to increase over time. You are only looking at things domestically. When you make a comparison globally, the US dollar buys more then most currencies. Gasoline is just one example.

Inflationist flat-earthers: gotta love 'em!

NidStyles's picture

That's not even close to being accurate.

Panafrican Funktron Robot's picture

There is a subset that buy into the "balance sheet recession" / Japan 2.0 scenario.  It's possible, we seem to be largely following the script to a T thusfar.  

sessinpo's picture

I will assume you miscommunicated your message.

For example, my IOUs would not become more valuable if I went bankrupt. But that is dealing with one person or entity using the same commodity for transactions or transfer of wealth.

In the global atmosphere, we are talking about competing currencies which is different, not the same commodity for transactions.

The US dollar is competing with the Euro. Each of them is competing with other currencies. That is why I keep on pointing out currency war. The US wants the Euro to be weaker because it makes it easier for the FRB to print.

I find it hilarious the back and forth claims of currency manipulation because that is what central banks do. They are in competition with each other. It cracks me up.

Panafrican Funktron Robot's picture

"The US dollar is competing with the Euro."

You're describing the surface level.  What else is going on?  USD vs. EUR is like Obama vs. Romney, same controllers at the top.  They couldn't give a rats ass as long as USD or EUR is dominant.  The actual fight:

Russia and China have been pushed into becoming frenemies.  This is extremely dangerous to the UK/US team.   

diesheepledie's picture

Exactly correct. The hyperinflationists don't consider the global picture. There cannot be hyperinflation in a reserve currency. Protection of that status is key, and fortunately the USA still has a strong enough military to undermine any other up and coming challengers. That is why Bush(s), Cheney, Rumsfeld, Kissinger, McNamara, etc were so great. They understood the wisdom of maintaining an unstable feudal world. The whole world needs to be be falling apart and looking like shit in order to maintain a stable dollar. We need war lusting neo-cons and economy destroying international mega-banksters to keep lighting brush fires around the world, fucking things up, so the the USA looks good. God Bless America!

akak's picture

This was worthy of MillionDollarBonus himself!

ich1baN's picture

"When new money is created on a grand scale, it must go somewhere and have some major consequences. One of these will be greatly increased volatility and instability in the economy and financial system." -- J. Anthony Boeckh, Ph.D (Chairman, Bank Credit Analyst 1968-2002,The Great Reflation, Boeckh Investment Letter)

aerojet's picture

They aren't increasing the supply of dollars in any way that people can make use of them.  I have long contended that the inflation hypothesis is wrong.  What the Fed is engaging in is a giant accounting fix--they are essentially making it possible for the big banks to remain solvent in terms of accounting.  If you look at it in propeller head terms, you begin to understand what the hell they think they're doing.  They are keeping the big banks from having to declare bankruptcy by siphoning off all of their bad debts and nationalizing them through monetization. This activity also allows oustanding credit (credit is money) to continue increasing so that the government can continue to kick the can with deficit spending.  That's it--you get no net inflation, only the typicaly inflation that credit growth (because credit is money) produces.  Instead of organic credit growth, it is a forced variety, which is quite inferior.  But again, you aren't thinking like an accountant. 

All of it is designed to keep the status quo alive as long as possible.  They don't want deflation because deflation (oustanding credit collapsing, dollar re-valuing) means the saver wins, and if savers win, debtors are going to lose their asses.  Debtors like the federal government, every municipality in the country, every pension plan, every big financial firm gambling using margin, etc.  So it's also never been about rescuing underwater home owners, they don't care about those people or the widows and orphans with pensions and CDs.

BlandJoe24's picture

I agree with the points in your first paragraph.  i would add that another reason for the fed to buy up MBS is to make the liability of all the fraud endemic to mortgage paper over the last years "disappear" (into the basement of the fed).

As far as your second paragraph, it depends on who you mean by "they".  if the "they" is "who's in control", than it seems to me it's the super-rich (via the banks and multi-national corporations they run).  And they:

- are the creditors, to whom the debtors (governments, states, people, big firms, etc) will be exponentially more beholden in a deflation (see comment in my post above).  creditors benefit (power-wise) in a deflation.

- have been saving - they (banks, etc.) are, by every account - hoarding cash in record amounts.  ie: they are anticipating deflation and the expotential rise in the value of cash that deflation brings.

-  are interested in keeping the status quo alive as long as it keeps funneling money and power in their direction... if/when that changes, and they need a new "quo" to make them rich and powerful, then they will advocate/control/move to that "quo" and - unfortunately - will likely do so regardless of the suffering it inflicts on others.



Sean7k's picture

We may never have hyperinflation or even high inflation. As Smith makes painfully clear- deleveraging is offsetting the effects of money printing. It is in a closed loop. 

The banks are losing asset value, but being refloated with new currency that is sterilized from buying treasuries and keeping large cash balances. By not giving new loans, the money merely makes up for their losses. Those losses are traded to the taxpayer via the FED. 

The taxpayer isn't being forced to pay the full tax bill, so he is blissfully unaware of the coming danger. 

At some future point in time, two things will happen: the FED will declare the debt and ask the government to pay. Two, people will suddenly realize not all assets have the value they thought they did. 

At this point, one of two things happen: one, the people accept it and the level of austerity necessary coupled with a huge diminishment in entitlements or, two, the people will revolt in some manner.

Either way, the bankers win. Austerity means interest payments forever in amounts beyond their wildest dreams. Revolution means warfare that is financed and a heavier yoke for the people or they lose out on fake money that cost them nothing, while they now use their gold to re-establish themselves in a global reset.

There is the possibility that the people wake up and just withdraw from the system, but when the biggest story in America concerns the return of union refs, I'm thinking Americans are too ignorant to act.


Raymond Reason's picture

That is the FAIT accompli.  FIAT is a faith based system, and when it is abused, people lose faith.  It is almost inconceivable that it would not lead to inflation, despite convincing arguments for deflation. 

Hubbs's picture

This exactly my  dilemna for investing in stocks. They may go up in price nominally, but to cash out, you need to pay the tax man in dollars, and who knows what you'll actually keep of that to buy tangibles/energy/food.  Then if the money suddenly floods the system as everyone realizes their $ holdings are worthless, you take another hit. In which case, many of the  "rich" (on paper) 5% also may have nothing.  So, watch how much land and gold they are acquiring.  They ain't stupid.

Catch-22's picture

... also, a trip into stocks involves a broker and the return OF your money, not the return ON your money, is still the biggest concern…

Killtruck's picture

Spot on, Stackers. Fuck yeah.