QE ISN’T ADDING NEW LIQUIDITY TO THE MARKET

I find it amazing how many people still believe that QE is adding all sorts of liquidity to the markets.  There is still a widespread belief that QE is inflationary and an addition of net new money (despite the rather simple accounting behind a QE transaction).  Well, it looks like a few notable people are finally starting to get it.  Some recent commentary by notable central bankers makes it clear that some are beginning to notice that QE has no real relationship with higher inflation (via Warren Mosler)::

Don Kohn (Former FRB Vice Chair): “I know of no model that shows a transmission from bank reserves to inflation”.

Vitor Constancio (ECB Vice President): “The level of bank reserves hardly figures in banks lending decisions; the supply of credit outstanding is determined by banks’ perceptions of risk/reward trade-offs and demand for credit”.

Charlie Bean (Deputy Governor BOE) in response to a question about the famous Milton Friedman quote “Inflation is always and everywhere a monetary phenomenon”:

“Inflation is not always and everywhere a monetary base phenomenon”.

In this week’s letter John Hussman dispels the myth that the increase in the monetary base is adding new liquidity:

“From the standpoint of prospective investment returns, it is important to recognize that the main effect of quantitative easing has been to suppress the expected return on virtually all classes of investment to unusually weak levels. It’s widely believed that somehow, QE2 has created all sorts of liquidity that is “sloshing” around the economy and “trying to find a home” in stocks, commodities, and other investments. But this is not how equilibrium works.

Here’s how equilibrium does work. Every security that is issued has to be held by someone, in precisely the form in which it was created, until that security is retired. Period. That means that if the Fed creates $2.4 trillion in currency and bank reserves, somebody has to hold that money, in that form, until those liabilities are retired. The money ultimately can’t go anywhere. If someone tries to get rid of their cash in order to buy stock, somebody else has to give up the stock and hold the cash. In the end, every share of stock that has been issued has to be held by somebody. Every money market security that has been issued has to be held by somebody. Every dollar bill that has been created has to be held by somebody. None of these instruments somehow “find a home” by going somewhere else or becoming something else. They are home.

So what is the effect of creating an extra $600 billion dollars of monetary base by having the Fed purchase $600 billion dollars of Treasury debt? The same thing that happens anytime any security is issued. Somebody has to hold it, and the returns on all other assets have to shift by just enough to make everyone in the economy happy, at the margin, to hold the outstanding quantity of all of the securities that have been issued. In practice, the only way you can get people to willingly hold $2.4 trillion in non-interest bearing cash is to depress the return on all close substitutes to next to zero. So short-term Treasury bill yields have been pressed to nearly nothing.

I’ve been hammering on this point for 6 months now, but an increase in reserves has no impact on net financial assets.  As Mr. Hussman describes it merely alters the mix of assets.  This is not inflationary in the sense that some Friedmanites might have you believe.  And it certainly does not increase the odds of some sort of hyperinflationary collapse.  There really isn’t new money in the system.  And the notion that QE is helping to fund the deficit is beyond nonsensical and displays a terrible lack of understanding when it comes to how the US monetary system functions.  The only thing QE is doing is generating a huge amount of confusion, making investors believe the Fed is printing money and altering investor perception so as to to induce a speculative boom in commodities that is now helping contribute to global turmoil….

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Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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