Shown below is a simple diagram of monetary stimulus. Easy money is supposed to reduce unemployment, through the agency of the Phillips curve and assorted other processes that aren’t working. Jeremiah has his own idea what’s blocking that second link, but for now let’s talk about the first one.
In the latest Fed action, Chairman Bernanke vows to “print money” until employment improves. If you read the fine print, the Fed has a 2% inflation target. This link is also blocked. Over the past four years, the Fed has created an unprecedented $2 trillion of new money. Now, they plan to add a steady drip of $40 billion per month, until inflation starts to rise.
This plan assumes that inflation will start to rise, gradually, and then the Fed will stop easing and check inflation by raising the interest rate. Let’s hope they’re right, because this plan sounds an awful lot like pouring sand onto a sandpile.
The sandpile dynamic intrigues mathematicians because, while the sand is poured at a steady rate, the slopes of the pile will shear off and collapse abruptly. Likewise, when the $2 trillion finally begins to circulate, it could all go at once – creating a dramatic spike in inflation or, to put it another way, a plunge in the dollar’s value. The total money supply, M2, is roughly $10 trillion.
This is a very tricky situation for the Fed. Everyone has been predicting that QE would cause rampant inflation, and yet we haven’t even gotten the 2%. When it does go, it’s likely to be sudden. On the other hand, recessions have been caused by central banks hitting the brakes too soon.