Will QE3 Lead to Inflation? Not a Chance…

Submitted by Wall St. Daily using our Trefis Contributor Tool

You can already hear the war drums beating.

If the Fed cranks up the printing presses for QE3, we’re going to see hyperinflation. This is the last straw. Buy some gold Krugerrands and stock up on canned goods.

Don’t give in to these fears, though.

The Fed’s already pumped billions into the system (though not technically through “printing” as so many like to say). And it hasn’t led to inflation so far.

You see, the Fed offered to pay interest on excess reserves that banks deposit with the Fed. This allowed the Fed to increase the money supply out of thin air. It was essentially a subsidy paid to the big banks, but it’s not an inflation driver.

Indeed, since the reserve program started, there have been no significant changes to inflation.

See for yourself.

Right now, the best bet for the big banks is interest on reserves. At some point, treasuries will begin to show a better yield again and the money will start moving into the economy. That’s when it’ll be time to reduce the money supply.

But until then you can forget worrying about inflation with QE3. But that still doesn’t mean another round of quantitative easing is the right move.

Rather than being a secret subsidy to the banks, an easy monetary policy may be a poison eating them from within.

The reason is simple.

Why QE3 Is Still a Bad Idea

The entire purpose of quantitative easing has been an attempt to keep banks liquid and head off deflation.

With deflation, prices and production drop, which lowers employment. Both sides of the equation – supply and demand – head lower.

However, a new paper from the Dallas Federal Reserve summarizes a good deal of research that suggests quantitative easing can create deflation just as easily as inflation.

The idea is, so much of our economy stems from finance that extremely low interest rates squeeze banks’ profit margins. This, in turn, will reduce their employment rates and willingness to lend.

With that in mind, an easy monetary policy leads to a decrease in aggregate demand and (potentially) deflation.

Besides, QE3 is unlikely to improve the economy. Why? Well, the biggest statistic scaring officials is the unemployment rate. And unfortunately, it appears that this level of unemployment may be stubbornly persistent. Mostly because current unemployment numbers are mainly concentrated on lower-skilled workers. So increasing jobs won’t necessarily fix the problem.

Bottom line: While you don’t need to fear a surge in inflation from QE3, it doesn’t mean it’s the right move. With the threat of deflation looming larger, it’s time to stop meddling and let the market take its course.

When Bernanke speaks tomorrow after the Jackson Hole meetings, we’ll see if he agrees.