Once upon a time, in the merry old land of America, the bankers were wealthy, the people were healthy, and the politicians were stealthy. Then there came to the land a Great Financial Crisis in the year two thousand and seven. The bankers were hated, the people felt cheated, and the politicians stayed crooked.
The great wizards of the Federal Reserve decided to convene in their laboratory to see what could be done. After months of laborious tinkering, they created a magical potion known as “QE” (short for “quantitative easing”). The first batch of the magical potion was unleashed on the people in the year 2009. Mortgage rates went from 6.25% to 4.5% and the US economy avoided a Great Depression. Then, toward the end of the year 2010, the great wizards of the Fed unleashed the second batch of the magical potion and called it QE2. Mortgage rates began to tremble, and the American people began to murmur. That is where our story begins…
Inflation vs. Deflation
The Federal Reserve is required by law to encourage stable economic growth while preserving “monetary stability”. Monetary stability simply means that the Fed should not allow too much inflation or deflation in the economy. Inflation is when the dollar loses value because it costs more to buy goods and services today vs. last year. For example, if it cost $10,000 to buy a car last year, and $12,000 to buy the same car this year, that is inflation. The purchasing power of your $10,000 lost value. Too much inflation is bad for the economy because it makes it very difficult for people and businesses to budget, plan for upcoming expenses, and pay their bills due to the cost of living increasing so quickly. This is what our country experienced in the 1970s.
On the flip side, deflation is when the price of goods and services in the economy goes down, and the purchasing power of the dollar increases in value. For example, deflation is when it only costs you $8,000 to buy the same car that cost you $10,000 last year. It seems that deflation is good, because prices are coming down, right? Wrong. What if you are the one trying to sell the $10,000 car? Not only do you keep losing money on paper as the price goes down, but buyers stop buying because they know they can get a better deal if they wait.
Deflation is bad for the economy because employers lower their wages, buyers stop buying, and the economy slows down considerably. This is what happened to our country in the 1930s. In fact, during the Great Depression, our country experienced deflation of around 30 percent.
If prices go down by 2% a year, is that good or bad for the economy? Bad; because we are all getting 2% poorer every year. We would hoard our money, and not buy cars or houses or anything else, because everything we buy will lose value. You see, even small amounts of deflation can be very bad for the economy because it becomes a vicious cycle downward.
On the other hand, what if prices go up by 2% a year? Sure it may cost us a little more money to live every year, but the values of our houses, our investments, and our incomes are also going up. We are all getting 2% richer every year. Not a bad deal.
That is what the Fed is trying to accomplish. They want the economy to grow by around 3% every year, and they want inflation to average around 2% every year. Right now, inflation is averaging around 1%, and in recent months, it actually hit 0% on a month-over-month basis. This is dangerously close to widespread deflation in the economy. Remember, deflation is what we experienced during the Great Depression.
Quantitative Easing (QE)
The Fed is prescribing a medicine called “quantitative easing” (QE), because they don’t want deflation in the economy. QE is when the Fed increases the “quantity” of money in the economy by creating more “bank reserves”. For example, if Bank A has $1 billion deposited with the Fed, the Fed credits Bank A with having $2 billion in their account by buying an extra $1 billion of Bank A’s Treasury securities (government bonds). Sometimes the Fed buys the government bonds on the open market from banks and financial institutions who own them, and sometimes the Fed buys the government bonds directly from the government. Remember, the US Treasury has a “bank account” with the Federal Reserve, and the Fed can loan money to the government by creating more reserves in the US Treasury’s bank account.