Q&A on QE3 – Part 2
Sorry for the delay on the last of the answers here, but I’ve been swamped lately. If you missed part 1 see here. So here goes nothing….
Colin – Cullen, Have you looked at the IMF paper revisiting the ‘Chicago Plan’? I don’t understand how private banks would operate under such a system.
CR – I haven’t read that entire paper, but I believe it’s a 100% reserve proposal. I don’t understand how that fixes anything. Banks don’t lend their reserves so if you force them to have a 100% reserve requirement then that just means they’ll borrow from the Fed when they need to. So I don’t see what this resolves? Maybe I am missing something?
2contango - If I understand it correctly, QE3 is designed to boost optimism. But in my mind, it signals we are headed into more turbulent waters. Does anyone else read it this way? And if so, won’t it negate any positive impact?
CR – Maybe the best way to think of QE3 is pre-emptive. For instance, had they been implementing QE before the housing bust we might not have seen some assets fall as much as they did because the Fed would have been in there actively putting a floor under markets. That’s essentially the idea behind the Bernanke Put. The problem is, it can cause distortions in markets which, in my opinion, only delays the inevitable. I wrote more about this here.
Dunca Cap - Can you explain, for those of us who wear conical hats, how the fed buying morgtage securities will lower mortgage rates?
CR – There’s some differing opinions on this. Some people actually say that QE should result in higher rates as the increased economic confidence will filter through the market and impact rates upward. Others claim it works by lowering rates through the Fed’s purchases which put downward pressure on rates. There’s a lot of controversy over these points and which one is accurate. I tend to believe that QE as it’s being implemented has not had a huge impact on the markets and price is generally remaining a function of the short-end of the curve and the weak economic environment. Since banks hinge all their rates off the overnight rate then Fed policy influences most rates in the economy by setting the spread on how profitable bank loans are. So when the Fed eases mortgage rates come down. If the Fed is seen as being easy for a long time then banks feel comfortable making longer loans at lower rates. That’s the general gist of it.
Calvin – Cullen, yesterday when QE3 was announced you said this is hugely bullish for T-bonds. But the last 2 days T-bonds have fallen in price, probably due to rising inflation expectation and asset allocation shift from bond to equity. Today you even had an article that mention the HA-CPI is a bit hot.
So how do you square away these conflicting positions (or are they just a case of short-term vs. longer-term situation)?
CR – This isn’t a short-term story. We’re talking about multi-years here. The Fed has been very clear that they’re going to remain easy until “at least mid-2015″. To me, that’s bullish for the bond markets. Now, that doesn’t mean prices can’t fall a bit in the near-term, but my thinking is this – if you are averaging into a bond position right now and continue to do so over the ensuing 6 months I think you have a very high probability of generating a respectable return until the Fed changes their easing stance.
Anonymous – who has “agency mortgage-backed securities”?
CR – Mostly banks and investment firms.
Tom - What did you think of Egan Jones comments which seemed to be MMT based 
Some market observers contend that a country issuing debt in its own currency can never default since it can simply print additional currency. However, per Reinhart & Rogoff’s ” This Time Is Different: Eight Centuries of Financial Folly ” , p.111, 70 out of 320 defaults since 1800 have been on domestic (i.e., local currency) public debt. Note, US funding costs are likely to slowly rise as the global economy recovers or the FED scales back its Treas. purchases (75% recently).
CR – I am not an MMT advocate, but this is one thing they certainly have correct regarding the USA. The USA has an institutional design in place in which it uses its banking system as a funding source through the requirement of Primary Dealers to bid at auction and maintain reasonable markets in government debt. This allows the government to always be able to procure funds. Additionally, even in a worst case scenario, the Fed can fund the government directly by buying debt on the primary markets. So there is no risk of insolvency in the USA. Only a risk of inflation possibly leading to hyperinflation. But this is a very different form of default than “running out of money” as many people seem to think we have….
yourejammingmeup - In light of this QE3 announcement, how do you think this new FED policy will affect the fiscal cliff, and more importantly, real estate?
CR – I don’t see any connection between QE and the fiscal cliff. Regarding real estate – again, I don’t see how QE has a lasting impact. Real estate has been in the dumps because private sector balance sheets have been wrecked and there’s no demand for credit. QE3 won’t directly fix private balance sheets because it’s a pure asset swap of bonds for reserves resulting in no change in net financial assets. So again, I don’t see how QE3 can bolster real estate unless you believe it’s having a substantial impact on rates and spending through confidence.
Alberto - Why Scott Sumner is the hero of the day, a professor with dubious or modest scientific background and zero market (that is human behaviour) experience, while this site which is proposing a different path which is much more sound and grounded on reality has still a few followers ? Is it (may be) because people like Sumner are essentially proposing an easy “look at this big pie in the sky” solution which is therefore much easier to accept ? Is it because the people who should lead are still in denial (and so we’re essentially fucked) ?
CR – I think a lot of people blew this out of proportion by connecting Sumner to the Woodford comments. Woodford came out after QE3 and said Sumner had zero impact on his work. So that’s that.
Bernie – This might be asking a bit much, but it’s worth a try. Do you have any perspective on legal issues affecting MBS? Based on this Reuters article it sounds like there may be troubles.
http://www.reuters.com/article/2012/09/14/us-foreclosures-courtcase-washington-idUSBRE88D1OF20120914
CR – I don’t think we should read too much into the ruling from one state….
Onthemoney – Where Egan-Jones goes, S&P and Moody’s follow…http://www.zerohedge.com/news/egan-jones-downgrades-us-aa-aa . Echoing Tom just above, I’d also be very interested in your response to E-J. I understand why it is theoretically impossible for a nation with a printing press and its own currency to default. I presume, not having Rogoff’s book to hand, that the defaults they refer to must therefore have been a result of runaway inflation.
Can you enlighten?
CR – Egan Jones just flat out has the operational realities wrong on this. They say:
“Issuing additional currency and depressing interest rates via the purchasing of MBS does little to raise the real GDP of the US, but does reduce the value of the dollar (because of the increase in money supply).”
QE does not add money to the private sector. It does not increase net financial assets. There is no evidence that it reduces the value of the dollar or causes sustained inflation. The trade weighted dollar index is flat since QE1 started. Treasury yields are down 1.5% since QE1. The annual inflation rate is flat since QE1. So no, I don’t think Egan Jones has this correct at all. Like most people, I think they’re completely misinterpreting the operational realities here.
jt26 - What’s your thoughts on gold and gold+TLT given the announcement? Personally, I think gold will be in a trading range unless stocks trade down or oil+Ag trade up.
CR – I’ll summarize my long-time bullish thesis on gold – negative real interest rates. I’ll also summarize my long-term bullish thesis on treasuries – as long as the Fed keeps short rates low the long rate will remain low.
John Wlikins - You have explained before that QE is an asset swap meaning, I think, exchanging cash for longer-dated Treasuries or other type of security, like MBS. Are those securities, when held by banks and other private sector considered part of the money supply. If they are not pat of the money supply doesn’t the payment of cash from the Fed to the private sector entity that the Fed buys the security from, increase the money supply? I have read many times, even from the Fed itself, that QE is not inflationary from a money supply standpoint (not counting psychological reasons or changes in the value of the dollar). So my question is, does QE change the money supply (disregarding potential changes in private lending due to interest rate reduction) or does the money supply remain the same?
CR – QE is an asset swap. The Fed buys assets from the private sector in exchange for bank reserves. This results in no change in private sector net financial assets. Before QE, the banks held a bond. After the sale they hold bank reserves. This does not change their net financial asset position as both reserves and bonds are an asset for the bank. Therefore, the money supply remains exactly the same. Banks do not lend out reserves so unless QE results in more lending due to some other reason then there is no reason to expect the money supply to increase from this.
jt26 - Do you think targeting unemployment and consumer deleveraging via QE is correct?
CR – It’s a supplemental policy. It is not the optimal policy. During a debt de-leveraging balance sheets are impaired which results in reduced spending and income. The optimal way to fix this is to increase the flow in the economy through fiscal policy. Lower taxes or more govt spending. This helps speed up the balance sheet repair process by increasing the flow of income as well as adding net financial assets to the private sector via bond sales. So no, I do not think QE is the optimal policy here. Hence my frustration with its repeated attempts….
jt26 - One thing that has been bothering me is that QE3 may actually prevent further lending …
CR – Lending is part supply, but mostly demand. If there’s no demand for loans then there are no loans to be made. During a balance sheet recession credit demand is weak because there is too much credit already relative to incomes. So you need to fix the balance sheets first. QE doesn’t do this. It’s a silly supply side policy that helps the banks clean their balance sheets and totally neglects the consumers whose balance sheets are the ones needing repair.
Wantingtoretire - What will Romney and Ryan do with QE3 as soon as they get in to power and what will be the consequences of these assumed actions…..?
CR – Sounds like Romney will give Bernanke the boot and end QE because they think it’s “money printing”.
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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23 Comments
Do you think the Fed buying MBS has anything to do with the expiration of unlimited Congressional support for Fannie’s and Freddie’s obligations at the end of 2012? I know that is only one of about a half dozen things that expire or hit on Jan 1, but it seems to me that Congress made F/F bonds the equivalent of Treasuries late in 2008, and the expiration of that guarantee could be more important than most people seem to let on. Anyone who needs to unload their MBS now has a place to sell them, right??
Hi Cullen -
Do you think the Fed has the necessary tools to fight unemployment the way they can fight inflation (money supply, etc.)? I think, the Congress has given the Fed dual mandate without the proper tools.
I would appreciate your thoughts on how can the Fed bring the unemployment down. Isn’t that why QE3 was launched?
Cullen,
I’m sorry to beat a dead horse, but I’m still confused. You said above that the Fed purchase of MBS’s is essentially an asset swap, MBS’s for reserves. You also said that banks don’t lend out their reserves, but if the increase in reserves from selling MBS’s creates excess reserves for a bank, can’t they loan those funds?
Banks don’t loan out reserves. Bank loans create deposits and they find reserves after the fact if necessary. Having more reserves doesn’t make them more able to lend.
Cullen how did those 80 countries go bust if they had their own currency? I realize you don’t know the case history of each of the 80 (neither do I) but according to EJ there have been 80 cases where a sovereign issuer of currency “went bust” – how is that feasible? I doubt there were 80 cases of “hyper inflation”?
I’d have to see each one. MR has never said that a country with its own currency can’t go bust.
But can anyone produce examples of an entity with a fiat currency defaulting on domestic debt?
The page 111 stuff and accompanying tables contains a hodge podge of details about “defaults.” Some defaults are not countries but to states/provinces. These of course are currency users not currency issuers. Some other examples of their classification of domestic default is the USA in 1933 refusing to pay Panama an annuity in gold. A debt in gold is not a debt in a sovereign currency. In Peru in 1985 deposits in US dollars (i.e. foreign currency) were forcibly converted to local currency. This is listed as one of the 70 domestic defaults! I could continue but you get the picture.
There doesn’t appear to be a case of a sovereign government with a fiat currency defaulting on debts issued in its sovereign currency due to inability to meet the debts.
Citing this stuff to argue that a currency issuer can default due to inability to pay domestic debts seems like a willful (and skillful given the coverage) misrepresentation of the facts.
No one has ever said that a country can’t simply decline to meet the debts — which is what the debt ceiling is about and what, I believe, Russia did in the 90s. But that simply confuses an unwillingness to pay with an inability to pay.
I guess a default is not defined by a country not being able to pay or deliberately not willing to pay its liabilities.
I would define a default when a large number of citizens (or another sovereign government) loses a big portion of wealth and savings as a consequence of the other governments (incl. states and provinces) inability to manage monetary and fiscal matters. And this will be the case in each of the 70 examples of default.
And I think it is cynical to think that only a wealth destruction by default is terrible (whether the default is deliberate or not) whereas the common sense here is that inflation (whether it is creeping inflation or high inflation) is a legitimate way of destroying the wealth and savings of citizens. In fact it is not only cynical when CR and others here claim that a “sudden” default is something completely different to a “creeping” default by inflation, in fact it is even dangerous.
Great comment.
Creeping inflation would only destroy your wealth if you are dumb enough to hold it in the form of dollar bills hidden under your mattress.
But most Americans don’t have wealth. They have income (declining) and bills (climbing.)
Even when they have wealth, it’s maybe a 100k retirement account, which needs to be held in cash or cash eqivalents.
You are also saying that a system that continually destroys the currency is a good one.
And the insinuation that most Americans are ‘dumb’ … geez, it’s almost grating enough to make me symapthize with Democrats! Those of us with assets need to make sure the system doesn’t destroy the working class, if only for our own interests.
Didn’t mean to insinuate that most Americans are dumb. Just Dave.
I’m kidding
But seriously, you folks who think the currency is being destroyed might find a more sympathetic audience on the Austrian blogs.
There’s a big difference between default by “running out of money” and default by inflation or hyperinflation. It’s perfectly normal to have a low rate of inflation in a growing fiat monetary system. Just study the 1900′s when US living standards exploded through the roof and inflation averaged 3.5% per year. Did we really go backwards just because of some low inflation? Of course not. And that’s primarily a function of the fact that producers made increasingly incredible goods and services. The problems arise when those producers stop producing goods and services that increase living standards. Then you just get more money creation on top of a stagnant living standard. Then things start to deteriorate and the currency becomes unstable. That’s not an accurate description of the USA though. So let’s better understand the real cause of hyperinflation and why a little inflation is not such a bad thing.
Dave the context in which the Reinhart & Rogoff “data” is being used is one of ratings of sovereign bonds. However there are no examples in that data of a sovereign issuer of currency defaulting because of an inability to pay.
That is really the only story here. Yes sovereigns can decline to pay. Yes sovereigns can mismanage their economies and in some cases that may lead to excessive inflation. And so on… I don’t think anyone has ever seriously argued that that can’t happen. But unless someone can produce an example of a sovereign defaulting on a debt in the currency they issue, because of an inability to pay the debt, then they really just accept that that is the case in the monetary systems we use and move on (and stop citing the R&R nonsense).
I’ve given you examples of why even a ‘little’ inflation — this steady drumbeat of 3, 4 and 5 percent annual inflation (higher when you consider energy and health care costs) — is so damaging to most Americans.
Why do you believe it’s a good thing?
Is it because high inflation makes your investments go up? Or is it inflation is the key to an economy (and a government) built on borrowing money now and paying it back with a devalued currency?
“Why do you believe it’s a good thing?”
straw man fallacy.
The question asked in this thread was about sovereign defaults. If you are unable to show an example of a sovereign currency issuer defaulting because of an inability to pay then take it elsewhere.
By the same token, repeating ad nauseum that we can never run out of ink for the printing press doesn’t address the question of whether the current trajectory is a wise one.
As for inflation, Cullen himself said that a ‘little inflation is a good thing’ … and present policy is to stoke inflation.
The real question, or problem, may not be a sovereign’s debt in its own currency, but a system where most of the ‘inside money’ actually in use is based on debt.
Such a system seems designed to produce a constant debt burden. in addition to inflation, that both fall most heavily on the household sector, which does not have a ‘printing press’; while acting pathogenically, if not carcinogenically, to ever increase the financial sector’s share of wealth and power.
REN’s arguments along this line have seemed highly persuasive, and although I’m not yet convinced ’100% reserve’ banking is the only solution, I am coming to see our current ‘(highly) fractional reserve’ system as fundamentally flawed.
80 should read 70 in the previous comments – 70 of 320
Thanks Cullen
“QE3 won’t directly fix private balance sheets because it’s a pure asset swap of bonds for reserves resulting in no change in net financial assets.”
So the Fed traded reserves for MBS, the interest goes back to the Treasury, but then what happens when the MBS mature? Does the principle go to the Treasury? I’m confused…
Cullen,
I know you claim that QE3 doesn’t increase the money supply. But could you help explain, when the Fed buys a banks MBS and gives the banks a “reserve” in return, what is that reserve, really?
I don’t quite understand what a reserve is if its not a treasury bond or cash. Also – whatever it actually is – because its more secure than a MBS, wouldn’t it make the bank more likely to loan out more money since that MBS is now a stronger instrument on its books?
And if so, wouldn’t this be increasing the money supply with more loans?
And finally, why would the Fed be doing this if it didn’t result in anything – please enlighten cause I cannot believe they don’t understand this.
Tim.
Tim, If I may interject here, the reserves are for calls on money held at the bnk. increasing reserves aids in making sure that the Proverbial “Run On Bank” they have enough to handle it. That’s really all it is for. AND the FED pay’s a small interest on it which can aid in achieving the target rate.
“3. Why is the payment of interest on reserve balances, and on excess balances in particular, especially important under current conditions?
Recently the Desk has encountered difficulty achieving the operating target for the federal funds rate set by the FOMC, because the expansion of the Federal Reserve’s various liquidity facilities has caused a large increase in excess balances. ”
Here’s a decent Read: http://www.newyorkfed.org/markets/ior_faq.html