Weekly Economic Update: September 25 – September 29, 2017

September 25, 2017

CHART OF THE WEEK

Fed to Unwind Quantitative Easing (QE) Starting in October

Last week, the Federal Reserve announced it would allow its outsized balance sheet (top chart) to decrease starting next month. The Fed had been purchasing unusually large quantities of U.S. Treasuries and mortgage-backed securities issued by government-sponsored enterprises (e.g., Fannie and Freddie) with newly issued bank reserves (monetary base, which includes currency), under a program it called large-scale asset purchases, a.k.a. quantitative easing (QE).

Two factors counteracted the five-fold increase in the monetary base from leading to a higher rate of inflation, which has consistently undershot the Fed’s 2% inflation target:

First, before the recession, every $1 of base money the Fed created resulted in about $1.75 more in circulation. However, since 2008, the “money multiplier” has decreased to 0.95 because banks have been lending at a slower rate.

Second, the rate at which money is exchanged, “velocity,” has slowed considerably since early 2008. Before the recession, a dollar held as currency or in a checking account was exchanged an average of eleven times per year; now the average is less than six times.

The decline of the money multiplier and velocity help explain why QE did not result in a higher rate of inflation.

LAST WEEK

This survey measures how much businesses’ cost of producing one unit of their product changed since the same month last year (an inflation rate measure) and how much businesses expect it to change by the same month next year (an expected inflation rate measure).

Noteworthy: Since this survey began in 2011, the period after November 2016 was the first time inflation expectations consistently averaged 2%. Previously, inflation expectations were consistently below 2%. In recent months, as actual inflation and other measures of expected inflation have fallen, BIE’s survey of expected inflation has likewise declined below a 2% average the last three months. Although the Fed does not use this specific survey to determine whether its objective of 2% average inflation is being met, these results signal that additional Fed interest rate hikes are less likely in the future.