Some people want you to believe that the Fed just injected the economy and stock market full of money that will now result in an economic boom and much higher prices in most assets.  That’s simply not true.  Here’s the actual mechanics behind QE.

Before we begin, it’s important that investors understand exactly what “cash” is.  “Cash” is simply a very liquid liability of the U.S. government.   You can call it “cash”, Federal Reserve notes, whatever.  But it is a liability of the U.S. government.  Just like a 13 week treasury bill.  What is the major distinction between “cash” and bills?  Just the duration and amount of interest the two pay.  Think of one like a checking account and the other like a savings account.

This is a crucial point that I think a lot of us are having trouble wrapping our heads around. In school we are taught that “cash” is its own unique asset class. But that’s not really true. “Cash” as it sits in your bank account is really just a very very liquid government liability. What is the difference between your checking and savings account? Do you classify them both as “cash”? Do you consider your savings accounts a slightly less liquid interest bearing form of the same thing a checking account is?

What is a treasury note account? It is a savings account with the government. So now you have to ask yourself why you think cash is so much different than a treasury note?  What is the difference between your ETrade cash earning 0.1% and that t note earning 0.2%? NOTHING except the interest rate and the duration.  You can’t use your 13 week bill to pay your taxes tomorrow, but that doesn’t mean it isn’t a slightly less liquid form of the exact same thing that we all refer to as “cash”.  They are both govt liabilities and assets of yours.

When you own a t note you really just traded your “cash” for a slightly less liquid form of the same exact thing.  If the Fed buys those t notes from you they give you back your cash minus the interest rate. That’s all there is to it. No change in the money supply. No change in anything except the rate of interest you were earning.  If the government removes t notes then all they’re doing is altering the term structure of their liabilities.   They’re not changing the AMOUNT of liabilities.

The other day, Ben Bernanke explained that he is not adding any new cash to the system via QE:

“Now, what these reserves are is essentially deposits that commercial banks hold with the Fed, so sometimes you hear the Fed is printing money, that’s not really happening, the amount of cash in circulation is not changing. What’s happening is that banks are holding more and more reserves with the Fed.”

This is very important because millions of investors are betting on the inflationary impact of QE.  But again, as Mr. Bernanke said there is no reason to believe that QE is inflationary.   Why?  Because they are not adding net new financial assets to the private sector.  The assets already existed!  They are merely swapping reserves for bonds.   They are giving the banks a checking account instead of a savings account.  What does this mean?  If Bank A owned a 1.2% 5 year note and they sell that note to the Fed they receive reserves earnings 0.25%.  Their savings account was changed to a checking account.  What changed?  Nothing.  Just the duration and rate of the paper.  The number of assets in the system is the exact same.   You can see this description in the following diagram (via Alea):

As you can see the net financial assets are UNCHANGED. They are merely changing the composition of the bank balance sheet.  The logical question that most people ask is: “where did the Fed get the money to buy the bonds?”  They didn’t get it from anywhere.  It truly is ex nihilo.  But it is not new money being injected into the private sector. It is merely being swapped with something that was already spent into existence.  Therefore, you’ll often hear that banks have new money to put to work.  That’s not true.  They had a 0.2% piece of paper that was already put to work and can be exchanged in markets for whatever they please.  There is not “more firepower” in the market following QE.  All that the Fed altered was the duration of the U.S. government’s liabilities.  The Fed took on an asset (treasurys) and also accounted for a new liability (the reserves).   But this transaction did not change the net financial assets in the system.

The point here is that from an operational perspective the Fed is not really altering the money supply.  There might be some slight market change in the bonds the Fed purchases, but this is offset by the fact that the private sector is losing interest income they would have otherwise earned.  For instance, in QE1 the Fed removed $1.2T in assets from the private sector.  Much of this was high yield paper.  We know the Fed turned over ~$50B to the U.S. treasury (its “profits”) from QE1.  What did the banks get in return?  They got a checking account at the Fed earning 0.25% or roughly $2.5B over the course of QE1.  So the private sector LOST ~$47.5B in interest income it would have otherwise earned.

So, now you must be asking yourself why the heck they’re even doing this to begin with.  Well, QE supposedly changes the term structure of the bond market.  Fewer 5 year notes should lower interest rates and entice borrowing, generate lending, make other assets more attractive, etc.  If you sell your bonds to the Fed and receive low interest bearing cash you might want to rebalance your portfolio.  Mr. Bernanke is hoping you will reach out on the risk curve and buy equities or corporate debt.  But the price you purchase those securities at will depend entirely on their fundamentals and the price that you and the seller agree upon.  If you run out and bid up risk assets just because you think the Fed is “printing money” then you’re making a mistake.  If you run out and buy stocks even though their fundamentals have not changed you are making a mistake.

This is probably best seen in the price of commodities presently where investors are hyperventilating over the “printed money” and buying up hard assets.  For instance, coffee prices are up 70% since QE started yet Howard Schultz, the CEO of Starbucks says the fundamentals have not changed at all in the last two months.  He claims the speculators are to blame (thank you for that Ben Bernanke!).  Inefficient market at work in real-time?   Sure looks that way and we can thank the Fed for causing the bubbly situation in commodities.  They’re advocating undue speculation, causing severe market distortions, driving down the dollar and rewarding speculators for further financializing this economy.

The Fed has caused this mass hysteria over a minor interest rate decline.  In short, there is not more cash in the system following QE. There is not more “firepower” with which to purchase equities.   Hopefully, the above description makes that very clear. This was most obvious in Japan where QE caused a brief 17% rally in equities as speculators leveraged up, jammed prices and then later realized that the slightly lower yields hadn’t really changed anything.  What happened next?  Their equity market fell 40%+ over the next two years.  QE was a great big “non-event”.  All it did was manipulate markets temporarily and cause a huge amount of confusion.

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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  1. Though QE itself may not be DIRECTLY inflationary, the effects of QE taking place in our fractional banking system will be inflationary. For instance, if the Fed replaces $100 of Treasury Bonds with $100 of reserves, then those reserves will very likely be lent out, redeposited, lent out again, etc, until the $100 bond has been turned into hundreds of dollars of loans, deposits, interest, etc. This seems to me to be an increase in the money supply and tthis inflationary.

    Saying that QE does not cause inflation seems to be like saying that gravity, and not the wings falling off, is the reason a plane crashed. Sure, replacing the wings with air didn’t directly cause the crash, but the natural result of that change did.

    TPC – Incorrect. Banks don’t lend out reserves. Your theory is the same one many worked under during QE1. There was a massive decline in borrowing durring QE1 as the chart in this post shows.

    • Adding on to what Tycoon was mentioning earlier and TPC’s response to that, the reserves are the % of deposits that FED requires the banks to hold with the FED. Now say a bank has the following Balance Sheet
      Assets Liab+Equity
      ——- ———–
      Reserves – 20 Deposits 180
      Loans – 100 Equity 20
      10Y Bonds – 80

      In this case FED has mandated a 20% reserve. The reserves are to ensure that the banks have the ability to service a % of their depositors who might withdraw the money suddenly. Now when the FED buys the 10Y Bonds from the bank, like TPC says, it will just take out the 80 from 10Y Bonds on the bank’s assets and will increase the reserves from 20 to 100. What this has also meant though is that banks now have 80 more in reserves to support their deposit base. In theory that means the bank could attract more deposits (retail or wholesale) of 400 which is what the 80 in reserves could support (80/0.2). This is cash that the bank can then lend out to its customers. Now this is 400 that has gone into the system. Let us say it goes out as loan to a business, who then buys machines etc and then that 400 will land as deposit at another bank, who can then lend out 320 (400*0.8). That customer then uses it for something else and the money then ends up at another bank who can then lend out 256 (320*0.8). It goes on until the amount becomes close to 0. Basically the fractional banking system will ensure that there is about 2000 more $$ put in movement with a 400 buy. (400/0.2).

      Reserve %, payment on excess reserves, short term fed funds rate, purchase of securities are all part of FED’s tools to manage the twin mandates of FED, namely stable employment, and low manageable inflation.

      Now for the caveats….The key question that nobody probably even Mr. Bernanke has an answer is how the QE will play out, because nobody has any experience in this segment. Putting on Mr. BB’s shoes he is expecting that QE2 will give an immediate boost to asset prices, thus infusing confidence for consumers to spend..and that companies might be able to borrow cheap or use the excess cash to invest etc etc.

      But that all depends on “demand”. As TPC has rightly pointed out, this does not seem like a supply issue anymore, but demand issue. Consumers are very very wary about spending, and unless data points move in the right direction firms are also weary of overspending. So the best that Mr. But I do believe that once consumers de-leverage their debts to a manageable levels, they will once again start spending. What that level of sustainable debt level is debatable but I would say it is around 100-110% debt/disposable income. Currently as a nation we are at 120% with a high of 128% two years back. Long run avg is around 100%. So I say another 2-3 years of de-leveraging. The best that Mr. BB can hope is that QE measures will give enough time for consumers to pay down their debt before they can start spending again. QE measures may or may not hit all the right targets, but without it a rise in rates will be absolutely catastrophic for the debt ridden consumer trying to pare down their debts to manageable levels.

  2. Hi,

    First and foremost, this site is a blessing who I wished I had stumbled upon sooner–just picking concepts here and there has been rewarding. As a high school student who admittedly doesn’t have a strong grasp on this whole banking system, and equally monetary and fiscal policies associate with it, I was wondering if you can help me understand the difference between the “reserve” and “deposit” items as they are defined on the balancing sheet of banks.

    Obviously, the deposit is what the bank’s customers keep for whatever reason. Where does this “reserve” accounting item come from? Is it some sort of equalizing liability-vs-asset, created on the balance sheet by the bank to balance out T-bond it purchases, reflexively through Fed, from government’s Treasury?

  3. Aren’t you ruling out the possibility that increased spending in the economy (as a result of QE) will lead to improved fundamentals?

  4. TPC you are wrong on many things.

    1) Demand for fiat currency does not come from government tax collection. It comes from interest on debt. Commercial banks create 90%(roughly not using precises figures) of money outstanding through loans. The borrower recieves a loan(created by the bank using fractional reserve). It becomes an asset for the bank and a liability for the borrower. So the balance sheet is square right? WRONG. Because the borrower must now enter the economy to obtain the “interest” on the loan. This ensures there is always a DEMAND for the currency in which the loan is issued through scarcity.(Not enough $$ to pay debt + interest) Someone is always extracting cash to pay the interest. This means that someone must also always be borrowing and spending to make that cash available. When that system breaks down, there is a sudden SHORTAGE of liquidity since there is not enough “cash” to obtain to pay principal + interest. This leads to “debt deflation”. Demand falls off a cliff and into a recession we go.

    This is where the Fed comes in. They attempt to mitigate this by giving the borrowers more breathing room to continue to borrow(lowering interest rates etc) At some point it is just impossible for borrowers to take on new debt, creating a shortage of cash to cover old debts. The highly leveraged system begins to break down. Capital is destroyed through initial credit missallocations.

    Once the initial attempt fails, government steps in and begins increasing its own debt load in order to keep the cycle going. The Fed merely ensures the government(spending debt mechanism) can continue indefinetly. OR SO THEY THINK.

    TPC – People don’t pay back their debts all the time. Big deal. They file bk and start clean. What happens when you don’t pay your taxes? Men with badges knock on your door. Big difference.

  5. The government and the fed believe by them continueing the debt process, they can stimulate private demand enough where the private sector can return to borrowing again. They can continue this ponzi scheme until either the government overwhelms itself in debt whereby

    1) By now the government is such a large % of the economy and carries such a debt burden that default is inevitable. However this would mean a massive deflationary collapse and all banking becomes insolvent. Total chaos, rioting looting. However the currency remains intact because of the liquidity shortage due to loans being called in at a large scale(panic).

    2) The government unable to continue borrowing monetizes its own debt until a political crisis leads to hyperinflation. Argentina, Weimar, Soviet Union Republics.

    TPC – The tsy market doesn’t fund anything in the USA….

  6. TPC – People don’t pay back their debts all the time. Big deal. They file bk and start clean. What happens when you don’t pay your taxes? Men with badges knock on your door. Big difference.

    But not on a large scale, when its large scale as in 07-08, system collapses period.

    TPC – The system didn’t collapse….

  7. An FRN note and a US government bond ARE NOT the same thing. This is an absurd claim. A bond is a claim on the US government to deliver FRN notes sometime in the future. An FRN note is a claim on the assets of the central bank which are usually DEBT instruments. This is why FRN notes are “liabilities”. Essentially you are correct that both are debt instruments but they are NOT equal to each other. Both are completely seperate “commodities”. Both are governed by the same supply-demand laws. The Fed and the US government are NOT the same entities.

    Final point. You claim that the role of the government is to essentially nurse the private sector? This notion is totally false and merely attempts to allocate a role to the state. This makes the assumption that the state is able to not only allocate resources more efficiently then the marketplace but also liquidate them better.

    TPC – Govt exists to serve the pvt sector. Not to “nurse” it. All currency is a debt to the govt. Read the writing on the top left of your dollars…..

  8. Final point again.

    The Federal Reserve by law is not allowed to purchase US debt directly from the treasury. This is why they must purchase from private banks and dealers. It is essentially a “stealth” bailout and monetization of the treasury. Some of you need to read the Fed Reserve Act.

    The most successful period in US history was actually the 1800′s during which prices were in a constant deflation and the value of money rose. This led to savings becoming more valuable and quality of living exploding higher. Goods became cheaper from productivity gains. All of this became backward when the Fed was introduced and Nixon turned debt into money.

    TPC – Monetization doesn’t happen in the current system. Bonds don’t fund anything….

  9. TPC – The system didn’t collapse….

    It didn’t? Thats only because the Fed stepped in along with mass scale government spending to keep the debt train going AS I EXPLAINED PREVIOUSLY. You are once again assuming the Federal Reserve and US gov are the SAME THING. This is completely false.

    TPC – Yes, the system remained intact because the govt provided stimulus and the lender of last resort made a market in credit markets….That’s the role of govt and the entire reason the central bank was created…..

  10. TPC – Govt exists to serve the pvt sector. Not to “nurse” it. All currency is a debt to the govt. Read the writing on the top left of your dollars…..

    This maybe true in theory. You should read the top of your dollars. FEDERAL RESERVE NOTE.

    Government does not serve the private sector. The number one goal of the state is SELF SURVIVAL. All other goals are secondary. Remember that concept.

    TPC – Self survival? I don’t even know what that means. Govt is not a living and breathing entity….

  11. “TPC – Yes, the system remained intact because the govt provided stimulus and the lender of last resort made a market in credit markets….That’s the role of govt and the entire reason the central bank was created…..”

    You don’t get it. Its a debt based monetary system. Someone must be constantly borrowing in order for it to work. At a given point the government itself will be unable to add debt. The central bank and GOV did nothing but kick the can down the road. At some point they will be powerless. Remember neither can create or allocate capital.

    “TPC – Self survival? I don’t even know what that means. Govt is not a living and breathing entity….”

    The role of the state is the same as any other corporation or individual. It is motivated and driven by self interests first and foremost. Survival is number one. State will do anything to keep a grasp on power. Study history.

    You state the government is here to serve the private sector. This sounds like someone who is merely attempting to justify the role of the state in the first place. For the government to “serve” the private sector it must be extremely dynamic and able to adapt to the ever changing needs of the marketplace. This is impossible because it violates rule number one that the government is motivated by its own self-interest first. Thereby how can it serve the private sector and itself at the same time? What you are attempting to justify is that central planning maybe used in certain circumstances and the government is able to allocate resources to the correct sectors. This has a documented history of being completely false.

    TPC – Okay. Let’s just agree to disagree.

  12. TPC wrote:
    The Fed took on an asset (treasurys) and also accounted for a new liability (the reserves).
    So, it looks like the bank is more liquid than it was before (it has reserves instead of treasurys).
    And, the Fed’s balance sheet remained balanced – the asset increased the same amount as the liability).
    Is that correct?
    Don Levit

  13. TPC,

    Congratulations for your website.

    Can or cannot banks create new commercial bank money because now they hold deposits (excessive reserves) at the Fed?

    Could they create commercial bank money “backed” by treasuries (your analogy=savings account), like they are allowed to do with deposits at the Fed?

    Thank you in advance

  14. Your article has gotten the basic concept wrong! Fed is creating money since the Bank’s reserve money increase from 50 to 90. The excess reserve can result in multiplier effect (every student of 1 st year economics should know this concept).

    With the extra EXCESS RESERVE, the bank is given extra fire-power to lend. Whether the money supply will increase will depend on higher demand by consumer (which has good credit standing) for loans.

  15. From an article I read, the excess reserves have increased exponentially compared to the required reserves.
    Banks are encouraged to maintain their excess reserves, and not make more loans, if the interest on these reserves is high enough.
    Is the interest on bank reserves paid by issuing additional Treasury securities?
    By the way, I bought the book “The Creature from Jekyll Island,” which deals with the Federal Reserve.
    Anyone read it?
    Don Levit