Monetization and Prices

I never meant to be so bad to you
One thing I said that I would never do
--Asia

Suppose the Fed, thru its debt monetization activities, creates $1 million out of thin air to buy some bonds from one of its primary dealers, JP Morgan (JPM). The Fed lifts $1 million worth of Treasuries, agencies, et al from JPM's inventory in exchange for the newly minted cash.

Being a financial institution, JPM is likely to put the money to work thru lending or investing activities. Let's say that JPM uses the $1 million for proprietary trading in stocks. It might even lever up its trading capital to get extra bang for the buck.

Regardless of how it is used, the bulk of the $1 million remains in the financial system somewhere. Unlike credit money that exists only as long as the borrower has appetite for leverage, money created for monetization purposes persists unless/until the Fed reverses its initial transaction and sells its bonds on the market--at which time the Fed reclaims and retires the $1 million that it had previously printed.

As expected, the $1 million that JPM deploys causes prices to rise while it is in the market. But because JPM and other financial institutions are the early beneficiaries of the newly minted cash, it is primarily the prices of financial assets that rise. Stocks, bonds, real estate...whatever the banks buy with the $1 million go up in price. Importantly, as long as financial assets go higher in price, most of the $1 million dollars of newly created money remains locked in the financial system.

This is why we do not see broad consumer price increases from central bank monetization activities--at least initially. Financial assets prices can shoot toward the moon (as we have seen) while the prices of break and milk remain relatively stable.

If for some reason prices of financial assets begin to fall, then the balance might shift. Lower prices will drive investors to sell and pull money out of the financial system. When this occurs, the $1 million is released from the financial system begins to make its way into the every day economy.

This is when we'll see the price of goods and services rise in earnest.

The formal propositions are as follows:

Proposition 1a: When money is created for central bank monetization activities, the printed money will be used by financial institutions to buy financial assets, thus driving asset prices higher.

Proposition 1b: When prices of financial assets subsequently decline, the printed money rotate out of the financial system into the everyday economy, where it will be used by consumers to buy goods and services, thus driving consumer prices higher

no position