Daily Data: How Quantitative Easing Could Be Deflationary

One of the scariest things about the Federal Reserve’s massive debt-buying program throughout the recession was its potential for fueling crippling inflation. Common sense economics implied that flooding the market with $3.5 trillion of new money could easily set off broader price increases, making life in hard times even less affordable. Anti-Fed politicians and talk show hosts sounded rabid warnings of such runaway inflation.

But months, and then years, of quantitative easing with only low interest rates to show for it led a small group of academics to speculate that the Fed’s actions were more deflationary than inflationary. Perhaps, these followers of economist Irving Fisher proposed, the artificially low interest rates that the Fed action created actually moderated price increases long-term. Research in the field, however, has been better at explaining how that might work in theory than in practice. These believers have remained solidly in the minority.

A forthcoming paper by John Cochrane of Chicago Booth offers a big dose of credibility for those contrarian voices. The findings, to be published in the Journal of Economic Dynamics and Control, suggest that quantitative easing-type policies can create consumption-encouraging inflation in the short term that reverts to healthier low inflation for the long term. Perhaps more importantly, the study shows how the Fed’s large balance sheet, as well as interest payments it now makes on reserves, allows this effect to happen.

The findings in Cochrane’s study run contrary to standard economic theories that shape monetary policies around the world, including in the United States. For example: Japan’s central bank has held interest rates at near zero for more than a decade in an attempt to jumpstart its anemic economy. If Cochrane’s findings hold, that policy may instead have helped create Japan’s periods of deflation—dangerous situations that can drive a suffering economy into depression.

Cochrane explains his results, including how they differ from the findings in conventional models, in several posts on his blog, “The Grumpy Economist.”