Sunday, November 28, 2010

Quantative Easing 2 & Inflation

Dr. John Lott has a column up at Fox News explaining why the enormous inflation of the money supply hasn't caused substantial price inflation yet.  Others have pointed out that the reason that hasn't been a problem is the low velocity of money at the moment.  Lott has another explanation, and one that fits well with China's outrage about QE2:

China is trying to keep the U.S. dollar more valuable than the Chinese currency, the Yuan. That sounds counter-intuitive, but a more valuable dollar means that it is relatively cheap for Americans to buy Chinese products – and that helps Chinese manufacturers’ sales.
While the M1 money supply has soared by $364 billion since August 2008 and the new currency we have printed up grew by over a trillion dollars, China alone has accumulated almost $500 billion in U.S. currency reserves, about $200 billion after netting out changes in China’s U.S. Treasury bond holdings. The exact increase in China's dollar reserves isn't precisely known by anyone outside of the Bank of China, but it is probably pretty close to the exact total. Other countries have also increased their reserve holdings of dollars.

The problem is that holding on to all this cash is really very costly for the Chinese. They can't turn around and spend the dollars, or all the additional dollars in circulation will again lower the value of the dollar -- defeating the very reason that the Chinese accumulated the dollars to begin with.

Read more:
Lott says that at some point, the cost of this program to keep the yuan artificially cheap is going to be too much for China to afford--and when that happens, the price inflation that should be associated with this enormous expansion of the money supply will happen.
While I agree that many countries (and not just China) are upset about the absurdity of what the Fed is doing, because the alternative is fiscal responsibility about our budget, it is hard for me to be very sympathetic to China, whose objectives are to continue to cheap yuan policy that has caused enormous economic distortions in much of the industrialized world, wiping out many manufacturing jobs.  
It does seem as though there is no hurry to buy bonds.  Once the inflation monster comes back, bond yields will have to rise dramatically as compensation.


  1. I'm confused by your "It does seem as though there is no hurry to buy bonds."

    When inflation hits, bond yields will rise, and thus bond prices will drop. So if you expect inflation, there's no sense in buying bonds.

  2. I expect inflation, but along with inflation will come rising bond yields. If 30 year Treasury bonds hit 8% because of inflation, I can retire and live on the interest income. Nothing makes better sense under those conditions. Gold? That's an inflation hedge--not an investment.

    Yes, high inflation will destroy the long-term value of those bonds, if it continues for a long time. But inflation so destroys the economy that it usually doesn't last. Responsible adults eventually take over the government.