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What central banks around the world seem to overlook is that by changing the mix of government liabilities that the public is forced to hold, away from bonds and toward currency and bank reserves, the only material outcome of QE is the distortion of financial markets, turning the global economy into one massive speculative carry trade. The monetary base, interest rates, and velocity are jointly determined, and absent some exogenous shock to velocity or interest rates, creating more base money simply results in that base money being turned over at a slower rate.

Economic growth and inflation do not arise from changing the mix of these government liabilities. Growth arises primarily from a) the channeling of scarce saving to productive investment that b) generates useful goods and services that c) can be purchased because the income paid to factors of production can – in a circular flow – be used to pay for that output. QE does nothing to aid this dynamic unless scarce bank liquidity is a binding constraint on productive investment or spending, which it presently is not. QE does not spur new demand in an environment where productive investment opportunities are satiated by the existing availability of loanable funds. It just provides cheap finance for speculative carry trades in the financial markets.

Meanwhile, inflation and hyperinflation typically do not arise from simply from changing the mix of government liabilities toward more currency. Inflation emerges primarily from supply constraints or an exogenous shock that reduces supply, coupled with fiscal policy where large government deficits are being used to finance consumption and transfer payments. In that environment, the marginal value of goods surges relative to the marginal value of a currency unit, and the mix of government liabilities held by the public doesn’t particularly matter. Financing the deficits with debt instead of money still results in exogenous upward pressure on interest rates and monetary velocity. Hyperinflation results when there is a complete loss in the confidence of currency to hold its value, leading to frantic attempts to spend it before that value is wiped out. I expect we’ll observe significant inflationary pressures late in this decade, but present conditions aren’t conducive to rapid inflation without some shock to global supply.

With regard to the recent move by the Bank of Japan, seeking to offset deflation by expanding the creation of base money, the move has the earmarks of a panic, which is counterproductive. The likely response of investors to panic is to seek safe, zero-interest money rather than being revolted by it. The result will be a plunge in monetary velocity and a tendency to strengthen rather than reduce deflationary pressures in Japan. In our view, the yen has already experienced a dramatic Dornbusch-type overshoot, and on the basis of joint purchasing power and interest parity relationships (see Valuing Foreign Currencies), we estimate that rather than the widely-discussed target of 120 yen/dollar, value is wholly in the other direction, and closer to 85 yen/dollar (the current exchange rate is just over 112). The Japanese people have demonstrated decades of tolerance for near-zero interest rates and the accumulation of domestic securities without any material inclination to spend them based on the form in which those securities are held. Rather than provoking strength in the Japanese economy, the move by the BOJ threatens to destroy confidence in the ability of monetary authorities to offset economic weakness – in some sense revealing a truth that should be largely self-evident already.