Who’s afraid of Jerome Powell?
I keep seeing these wonderful charts of central bank balance sheets everywhere. Maybe it is because I am so adamant that Quantitative Easing (QE) isn’t going to create inflation that I notice them everywhere. But then again, there is a reason these charts pop up time and again. After all, the Federal Reserve has increased its balance sheet by $2.8tn (13.6% of US GDP) between January and July 2020. The Bank of England has expanded its balance sheet by $306bn (10.7% of UK GDP) and the ECB by $2.3tn (19.9% of Eurozone GDP) over the same time period. All this money has to go somewhere and when it arrives in the economy, it will not only create growth but also inflation.
But unlike in 2009 and 2010, when we were in truly uncharted waters, we now know how QE works. We had more than a decade to study its impact on economic growth and inflation. A group of researchers recently examined all the studies done on the impact of QE on growth and inflation over the years. In the United States, they found that QE to the tune of 1% of US GDP increases the price level by 0.21%. In the UK, the price level rises by 0.04% and in the Eurozone by 0.11%. If we apply these findings to the balance sheet expansion of central banks in 2020 so far, we come to an expected increase in the price level of 2.9% in the United States, 0.4% in the UK, and 2.2% in the Eurozone.
Cumulative impact of 2020 central bank balance sheet expansion on price levels
Source: Fabo et al. (2020).
Note, that this is an increase in the price level, not an increase in inflation. What these numbers mean is that if the total effect of QE would be felt in one year, inflation rates in the United States would go up by 2.9 percentage points in that year and then go back to the previous level without QE. If the effect of QE is felt over two years equally, then inflation rates in year 1 and 2 would be 1.45 percentage points higher before falling back to pre-QE levels and so on. In other words, the impact of the balance sheet expansion by central banks in 2020 will be very small at best. What we need for inflation to really get out of hand is much more balance sheet expansion than we have seen in the financial crisis and during the Covid pandemic and not just once or twice, but every year for the foreseeable future. So, if you are afraid of Jerome Powell, Andrew Bailey, or Christine Lagarde, you shouldn’t be. They are harmless.