In science, there are lots of facts, but only a few theories. Fewer still, perhaps, are the “laws” of science, one of which is the Law of Conservation of Matter, which holds that matter can neither be created nor destroyed. The laws of science, however, aren’t good enough for the Federal Reserve — you see, the Fed creates money.
Since the financial crisis of 2008, the Federal Reserve has created trillions of new dollars. The Fed creates money when it buys assets, which is called “quantitative easing,” or QE. The assets the Fed buys can be “whatever assets it likes: government bonds, equities, houses, corporate bonds or other assets from banks.” For instance, when it launched QE2 in Nov. 2010, the Fed bought $600B in U.S. Treasury bonds.
Just as the Fed creates money, it also destroys money. The Fed destroys money when it sells assets. When the Fed sells its assets, it takes money out of the system; that money is then no longer out in the economy where folks can use it. (I’m not sure if the Fed hits the delete button when the checks for its sales clear, or if that even matters.)
One would think with so many trillions of new dollars pumped out into the world that “price inflation” would erupt. That hasn’t happened because the Fed’s new money isn’t circulating; it’s “sitting on the sidelines.” That the Fed’s new dollars are idle may be a boon, respecting price inflation. For if commercial banks were indeed loaning their new money out, the number of dollars in the system would be even greater than what the Fed has created. That’s because of the money multiplier of our “fractional reserve” banking system. But, if the Fed’s new money started to be used in the economy, price inflation should return. In which case the Fed would need to end QE and begin what analysts call the “exit strategy.” Continue Reading →