Does QE Create Inflation?

Analyzing whether Quantitative Easing creates financial conditions that lead to higher CPI inflation.

There is currently an argument that if the Fed were to restart QE, it would lead to inflation increasing before the Fed got inflation back to its 2% target. 

In this report, we dig into the mechanics of QE, the correlation between QE and CPI, and possible causal outcomes from QE impacting inflation. 

Breaking down QE

To understand how the mechanisms of QE could affect inflation, we must first deeply understand the mechanics of how QE itself works.

Since 2008 when interest rates hit zero, the Fed began to engage in Quantitative Easing, commonly referred to as QE.

The Federal Reserve initiates QE by purchasing a substantial amount of financial assets, typically treasury bonds or mortgage-backed securities, from the open market. The Federal Reserve transacts with a group of financial institutions known as primary dealers. These dealers are authorized to trade directly with the Fed in the open market and include major banks and securities firms. The primary dealers act as intermediaries between the Federal Reserve’s NY Trading Desk and the broader financial markets. 

As these primary dealers bid to the Fed, it determines the purchase price based on the bids received. The goal is to inject a specific amount of money into the banking system and the accepted bids become the basis for the transaction prices, and the Federal Reserve credits the accounts of the selling institutions with the purchase amount. As the Federal Reserve acquires these assets, it credits the accounts of the selling institutions with newly created reserves, called Central Bank Reserves. This process effectively adds to the banking system's reserves, increasing the overall money supply.

This QE process causes a few things to occur: