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Assets compete. If you create a huge volume of non-interest bearing money, somebody somewhere has to hold it. So long as close substitutes such as Treasury bills offer any competition at all, investors try to shift out of the non-interest bearing stuff into the interest-bearing stuff. Of course, in equilibrium, that sort of shift is impossible in aggregate since somebody still has to hold the money. So the result of the Fed's quantitative easing is that short-term interest rates have dropped to about zero. As long as that happens, people are OK holding the money, and you don't need to have inflationary consequences, but the sensitivity to small errors becomes magnified. Meanwhile, QE has also caused investors to seek out riskier assets, and the result has been an increase in stock prices, commodity prices and a variety of speculative securities. As prices rise, prospective future returns fall. The process stops at the point where all assets, on a maturity- and risk-adjusted basis, are priced to achieve probable returns near zero
And so here we are.
There are a few possible outcomes as we move forward. One is that the economy weakens, and the Fed decides to leave interest rates unchanged, or even to initiate an additional round of quantitative easing. In this event, it's quite possible that we still would not observe much inflation, provided that interest rates are held down far enough. Unfortunately, the larger the monetary base, the lower the interest rate required for a non-inflationary outcome. T-bills are already at less than 4 basis points. In the event of even another $200 billion in quantitative easing, the liquidity preference curve suggests that Treasury bill yields would have to be held at literally a single basis point in order to avoid inflationary pressures.
A second possibility is that we observe any sort of external pressure on short-term interest rates, independent of Fed policy. In that event, the Fed would have to rapidly contract its balance sheet in order to avoid an inflationary outcome. As noted above, even a quarter-percent increase in short-term interest rates would require a full-scale reversal of QE2. Alternatively, the Fed could leave the monetary base alone, and allow prices to restore the balance between base money and nominal GDP. In order to accommodate short-term interest rates of just 0.25% in steady-state, leaving the monetary base unchanged at present levels, a 40% increase in the CPI would be required. I doubt that we'll observe this outcome, but it provides some sense of what I mean when I talk about the Fed pushing monetary policy to its "unstable limits
Originally posted by cpdaman
the fed has up to now orchestrated a tremendous rally in assets ...cept housing.....and given the can a large kick down the road ........the fed is now DANCING on the edge of a KNIFE ...not much room to thread the needle ....