Quantitative Easing, Inflation, and the Value of the U.S. Dollar
In the fall of 2010, the U.S. Federal Reserve decided to expand the U.S. money supply by entering the open market and purchasing $600 billion in U.S. government bonds from bondholders, a technique known as quantitative easing. Where did the $600 billion come from? The Fed simply created new bank reserves and used this cash to pay for the bonds. It had, in effect, printed money. The Fed took this action in an attempt to stimulate the U.S. economy, which, in the aftermath of the 2008–2009 global financial crisis, was struggling with low economic growth and high unemployment rates. The Fed had already tried to stimulate the economy by lowering short-term interest rates, but these were already close to zero, so it decided to lower medium- to longer-term rates; its tool for doing this was to pump $600 billion into the economy, increasing the supply of money and lowering its price, the interest rate.
Critics were quick to attack the Fed’s moves. Many claimed that the policy of expanding the money supply would fuel inflation and lead to a decline in the value of the U.S. dollar on the foreign exchange market. Some even called the policy a deliberate attempt by the Fed to debase the value of the U.S. currency, thereby driving down its value and promoting U.S. exports, which if true would be a form of mercantilism.
On closer inspection, however, these charges seem to be unfounded, for two reasons. First, at the time, the core U.S. inflation rate was the lowest in 50 years. In fact, the Fed actually feared the risk of deflation (a persistent fall in prices), which is a very damaging phenomenon. When prices are falling, people hold off their purchases because they know that goods will be cheaper tomorrow than they are today. This can result in a collapse in aggregate demand and high unemployment. The Fed felt that a little inflation—say, 2 percent per year—might be a good thing. Second, U.S. economic growth had been weak, unemployment was high, and there was excess productive capacity in the economy. Consequently, if the injection of money into the economy did stimulate demand, this would not translate into price inflation, because the first response of businesses would be to expand output to utilize their excess capacity. Defenders of the Fed argued that the important point, which the critics seemed to be missing, was that expanding the money supply only leads to higher price inflation when unemployment is relatively low and there is not much excess capacity in the economy, a situation that did not exist in the fall of 2010. As for the currency market, its reaction was muted. At the beginning of November 2010, just before the Fed announced its policy, the index value of the dollar against a basket of other major currencies stood at 72.0623. At the end of January 2011, it stood at 72.1482—almost unchanged. In short, currency traders did not seem to be selling off the dollar or reflecting worries about high inflation rates.
Sources: P. Wallsten and S. Reddy, “Fed’s Bond Buying Plan Ignites Growing Criticism,” The Wall Street Journal, November 15, 2010; and S. Chan, “Under Attack, the Fed Defends Policy of Buying Bonds,” International Herald Tribune, November 17, 2010.