Quantitative easing and asset bubbles

The Fed’s quantitative easing moves are lately getting more attention. Rebecca Wilder gives a good summary description for quantitative easing. Under a QE policy, the Fed increases bank reserves beyond levels consistent with ZIRP (technical definition according to Bernanke, Reinhart, and Sack). QE implies that the Fed no longer targets an interest rate.

The flood gates are open. The Fed is injecting the banking system with shiny new reserves (liquidity) and is no longer using open market operations to keep the effective federal funds rate – the overnight interbank loan rate – close to its target, currently 1%. The Fed is not printing money, rather it is printing high powered money, where high powered money is the monetary base (reserves).

Will the Fed’s QE strategy lead to inflation? In the short-term, no. The money multiplier is falling because the economy is in a nasty recession alongside a serious credit crisis. In this environment, the surge of high powered money will not cause prices to rise.

But what happens when the economy rebounds? Inflation becomes a serious risk if the Fed does not extract the high powered money. If the Fed gets it wrong, or its timing is off, then the money supply will rise quickly as banks start to lend more freely, and inflation results.

More asset bubbles are the likely consequence of this easing. When the economy improves, this new currency will likely move back into commodities, perhaps the equity of commodity companies will also benefit. Increased lending activity (QE's intended result) will perhaps be focused on this narrow area also. Will Bernanke know at what level we are again in a bubble? Will anyone?