QE4 is Coming; Will Inflation Follow?

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Many observers expect the U.S. Federal Reserve to announce another round of quantitative easing, or QE4, this afternoon following the Federal Open Market Committee (FOMC) meeting.

The consensus is that the Fed will purchase an additional $45 billion of bonds from the secondary market each month.

That means the Fed would replace the monthly $45 billion used to swap short-term Treasuries for long-term Treasuries under Operation Twist, which expires at the end of this month, with outright bond purchases.

In addition to the $45 billion a month used in Operation Twist, the Federal Reserve Bank has been purchasing $40 billion of mortgage-debt securities monthly in its continued effort to boost growth.

In total, the market expects the Fed to continue to purchase $85 billion worth of bonds on the secondary market each month for the foreseeable future.

Now some investors fear the Fed with QE4 will seal the deal on skyrocketing inflation - but it takes more than increased money supply to raise prices.

QE4 and Inflation

James Bullard, President and CEO of the Federal Reserve Bank of St. Louis said in a presentation on Dec. 3, "[O]n balance I think it is reasonable to think that an outright purchase program has more impact on inflation and inflation expectations than a twist program."

Bullard continued, "Replacing the expiring twist program one-for-one with outright purchases of longer-dated Treasuries is likely a more accommodating policy. If the goal is to keep policy on its present course, the replacement rate should be less than one-for-one."

But for QE4 to create inflation, there needs to be a combination of liquidity and "normal" interest rates.

Inflationary fears are based upon a normal interest rate structure and an assumption that the velocity of money (the amount of gross domestic product (GDP) that is generated by each dollar of money supply) will remain constant.

However, if interest rates are zero, as they are today, the velocity of money drops significantly, as you can see in the accompanying chart.

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