QE3 – A Brief Analysis

This is an interesting statement from the FOMC.  They announced QE3 in the form of $40B per month MBS purchases.   This will bring total monthly purchases to $85B per month.  They also said rates were likely to stay low “at least through mid-2015″.   It’s the wrong policy approach in my opinion.

First of all, QE is a simple asset swap of reserves for bonds.  In this case they’ll be buying MBS.  So it’s important to understand that the net financial assets of the private sector are unchanged here.  QE1 was different.  What the Fed did was essentially put a floor under assets that were selling at 30-40 cents on the dollar.  This was hugely bullish for the banks and the broader economy as it helped stabilize the economy enormously.   The recent QE’s have had a far more muted effect as these assets are all selling at par or above.

It’s also important to squash the myth that QE helps “monetize the debt” or fund the government.  This implies there is not enough demand for government debt.  This is patently false.  The US government uses the banking system in the USA to fund itself.  Primary Dealers are required to bid at auctions.  The only environment this wouldn’t occur in is a hyperinflation or an environment where inflation was very high.  This environment of de-leveraging and deflation is not remotely similar to such a situation.  Regardless, demand for government bonds has been very high throughout the crisis. As the world’s dominant output nation, US Treasury Bonds continue to appear far safer than most other bonds.  So the idea that the USA needs the central bank to fund its deficit flies in the fact of a mountain of evidence saying otherwise.

Now to the meat.  Remember, QE “works” in several different ways.  The primary way it works is by influencing interest rates and influencing credit channels, however, this policy doesn’t target rates as most monetary policy does.  Instead, it targets a size of purchases.  This doesn’t help set rates.  And at the end of the day central banks are price manipulators.  They manipulate prices by setting prices.  Not by letting the market decide price.  This strategy does not set prices so its impact on interest rates is far more muted than it could be.  That means the impact is muted.

The other primary transmission mechanisms are through portfolio rebalancing and so-called “wealth effects”.   It’s clear that QE has a powerful psychological impact as most people think it’s “money printing” and causing inflation.  This causes temporary market distortions.  The wealth effect theory is intriguing, but equally misguided.  Market prices reflect the future cash flows of underlying assets.  They do not reflect the future buying of central banks.  So this sort of policy puts the cart before the horse.  It is like a corporation who reinvests no money back into its operations and instead jams its stock price higher thinking this will impact the underlying assets.  It’s completely backwards thinking.

My general opinion here is that this was a big mistake by the Fed.  As I mentioned earlier in the week, I would have held off if I were running the ship.  Now the Fed is at risk of having the tide come in and everyone realizing they’re swimming naked.  They’ve essentially bought high with the S&P trading near its all-time highs.  So an economic downdraft and a subsequent market decline has the potential to severely damage the impact of future Fed policy.  I personally would have held off entirely.  Or if I were going to implement the policy I likely would have set long rates at 0.5-1.0% and left the purchases open-ended.  Clearly they did neither.  So now we’ll see if the Fed is indeed swimming naked.  I fear they are now at risk of exposing themselves.

The full release is below:

Information received since the Federal Open Market Committee met in August suggests that economic activity has continued to expand at a moderate pace in recent months.  Growth in employment has been slow, and the unemployment rate remains elevated.  Household spending has continued to advance, but growth in business fixed investment appears to have slowed.  The housing sector has shown some further signs of improvement, albeit from a depressed level.  Inflation has been subdued, although the prices of some key commodities have increased recently. Longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.  The Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions.  Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook.  The Committee also anticipates that inflation over the medium term likely would run at or below its 2 percent objective.

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month.  The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities.  These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.

The Committee will closely monitor incoming information on economic and financial developments in coming months.  If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.  In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases.

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.  In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Dennis P. Lockhart; Sandra Pianalto; Jerome H. Powell; Sarah Bloom Raskin; Jeremy C. Stein; Daniel K. Tarullo; John C. Williams; and Janet L. Yellen.  Voting against the action was Jeffrey M. Lacker, who opposed additional asset purchases and preferred to omit the description of the time period over which exceptionally low levels for the federal funds rate are likely to be warranted.

 

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Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.

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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  • GreenAB

    now it gets really interesting.

    -psychology. the stock market is all about expectations. this holds true for earnings reports but also the fed imo. it could be very fast that the market gets used to QE. then what would they do if equities start falling? there will be all cries for even MORE QE, yet they can´t do it. i agree with Cullen – they boxed themselves into a corner. it might be that we´ve seen the death of the Bernanke put today.

    -with no clear need for QE i expect (commodity induced) inflation expectations to rise, causing treasury yields to jump despite QE. btw: core PPI +2.5% today
    with MBS QE on the table now the market might challenge the fed over treasuries. it might just take one more push. technicals are ripe for a long term reversal.

  • Mark

    Isn’t QE inflationary so much as the fed is paying above what the market would have normally paid for these assets?

  • http://breedinginstability.com Mountaineer

    “If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.”

    That ‘substantially’ that the Fed threw in there seems like a pretty significant shift. Of course, they added the caveat in the end concerning inflation, but they made clear multiple times that even when extending the outlook into the long-term ‘inflation expectations remain stable.’ It could be meaningless jawboning, and it’s obviously a highly subjective means of analysis, but it could still be very important. It at least appears like the ‘high unemployment is a national tragedy, is not structurally founded, and should be addressed at all costs’ contingent is gaining influence.

  • http://www.conventionalwisdumb.com Conventional Wisdumb

    Cullen, did you write this before or after the release?

    If after, man you are a fast and cogent writer :)

    Who knew that President Obama was a believer in trickle down economics?

  • jt26

    Implicitly, it sounds like they are willing to risk higher inflation for lower unemployment … at least that’s the “theory” anyways. I think they are going to find out that there will be very little real growth, which means a small employment growth with much larger inflation, i.e. for 5% NGDP growth we’ll have 4.5% inflation, 0.5% real growth, and 0.2% employment growth. Actually, I’m not concerned about the the *financial industry* blowing another bubble since new capital rules should kick in over this same time period. But, they’ll force pension funds to take exorbitant risks. I think the Fed is just daring us to drive REITs to 3% FFO yields, but as people see inflation at that same yield they’ll start to get very nervous and the bust will destroy everyone’s faith again.

  • SJE

    “So now we’ll see if the Fed is indeed swimming naked. I fear they are now at risk of exposing themselves.”

    As in by reducing rates to near 0% with very little effect on economy and unemployment, and have no more tools to use. Trying to create demand during a balance sheet recession is proving very difficult to do. Seems that average person is more interested in paying down debt that making a new purchase because rates are low.

  • http://www.pragcap.com Cullen Roche

    Mark,

    I did an analysis on this last year. By my estimates, they’re not overpaying. and if they are, it’s not by a substantial amount. http://pragcap.com/is-the-fed-overpaying-for-bonds

  • http://www.pragcap.com Cullen Roche

    I’ve been writing similar articles for years now. The words fly off my fingers because I am a broken record. It’s not a special talent. :-)

  • ES71

    The definition of insantity ….
    Do we really need lowere mortgage rates? People who can afford houses already have them. Those who can’t, can’t afford them still.

  • barak

    i think they can have it both ways: higher inflation AND higher unemployment as inflationary pressures from comoddities (assisted by china’s stimulus to some degree) will cut a hole in the consumer’s pocket.
    cullen, this week Hussman talked about the risk of fed losses on his holdings forcing the government hands to finance it, and so enacting fiscal policy instead of monetary one. what’s your take on that?

  • KB

    Cullen,

    The first question that comes to mind after reading the statement is – what did they see in the economic data??? The “U” word behind the statement coupled with recend discussions of GDP targeting say a lot….
    Looks like ECRI is right after all, and we are indeed in the recession now. However, technically, your point of view will prevail, and we will not see any meaingful slow-down before year-end.
    And, obviously, Obama will be re-elected.

  • http://neweconomicsynthesis.wordpress.com/ Britonomist

    Good post.

    I think there is some justification for QE3 in a strategic sense; I’m pretty sure the markets would have tanked had the Fed announced no additional easing since 99% of market participants expected QE3, unexpected tightness relative to expectations often causes major drops in the stock market. I don’t think any of them were actually planning on QE3 initially but when the market plus Goldman & co basically decided that QE3 is happening whether you like it or not, this put enormous pressure on the fed to not disappoint them. I also think Bernanke is being pretty brave in doing this, he’s going to get a lot of flak for this. I kinda respect him for itsomewhat because I’m pretty sure that anyone who is more concerned with his own image than the economy would not have done this.

  • http://neweconomicsynthesis.wordpress.com/ Britonomist

    Sumner has an interesting take:

    “Nope. Long term yields increased on the news, just as market monetarist’s would have expected. And thank God they did! The higher yields are an indication that markets have (slightly) raised their NGDP forecasts going forward. The jump in equity markets suggests that RGDP growth will also rise (albeit modestly.) The bad news is that 100 points on the Dow is indicative of a really small change in the RGDP growth rate, basically within the margin or error. So we’ll never know any more than we know right now about whether the policy will “work.” Of course that won’t prevent hundreds of economists from making silly pronouncements a few months from now, based on actual changes in RGDP. I beg you to ignore them all.”

  • http://onlypricesmatter.wordpress.com/ B Ferro

    I disagree that they’re in trouble if the economy does get worse.

    As others have noted, the language has changed.

    The requirements for ending QE are are now basically a “significant” and “substantial” improvement in economic conditions.

    Since we all know those will never come, this is open-ended QE.

    Open ended QE means their bullets are now effectively unlimited.

    This is a major change as we all believed prior that they had “one” bullet left and they could/would fire it only in an emergency.

    Bernanke has now rendered that argument mute and at the same time has torpedoed Romney’s election chances [he will still get my vote :)].

    They called Greenspan “the maestro” but come on, Bernanke is pure genius.

  • Anonymous

    So….. the FED is now done. One less thing wall street needs to worry about.

  • http://None Midas II

    Who does the Fed buy mortgages from? If I understand this, its from the banks holding many failed mortgages. This helps the banks, but again, what does it do for main street? The $9 an hour jobs now growing can’t afford mortgages.

  • http://www.pragcap.com Cullen Roche

    Not done. But the risk is a downturn here that would severely hurt credibility of future QE programs.

  • Student

    Cullen, would you classify the first round of QE as “money printing” if the Fed was buying assets that were trading at 30-40 cents on the dollar? If not, why?

  • http://www.pragcap.com Cullen Roche

    History has yet to judge Dr. Bernanke. My guess is it will judge him the same way Greenspan was judged. As a man who misunderstood the economic machine, but tried feverishly to keep the machine humming.

  • Hans

    Bank Bernank, is nothing more than a naked tool for the administration.

    BTW, does anyone know who was the nay vote?

  • http://www.pragcap.com Cullen Roche

    Yes, as in, it was inflationary to the extent that it avoided deflation that would have been much worse.

  • http://onlypricesmatter.wordpress.com/ B Ferro

    You might be right (probably will be).

    I am a huge believer the “full employment” aspect of their dual mandate should be stripped by Congress.

    You run a great site, but I wish you would use this platform to espouse that view as well, as I believe this policy has had one of the (if not the) most deleterious long-run impacts on the global economy (especially U.S.) as any that exists.

    It’s such an easy policy change and would overnight cure a material portion of the long-run driver for global debt accumulation and imbalances – the Fed using its tools to prop asset prices via overly low rates and policies.

    Regardless, to your original point…

    It seems so irrational to all of us but they DO have two mandates and are failing on both.

    Bernanke may be disengenuous by not being more fervent with Congress about their short-comings in a ZIRP environment, but in the end these guys are just attempting to “be good at their jobs” by taking the steps required to fulfill their mandate.

    It’s like asking all of us to “not try” at our jobs despite the job descriptions we agreed to.

    In their eyes, completely rational what they’re doing.

  • hfm

    The only thing that does matter is if you trade against it or with it.
    It is stupid and high risk policy. Everybody knows that. Ben knows that too. Do you want to be right or you want to make money? That is your choice.

  • GreenAB

    “Open ended QE means their bullets are now effectively unlimited.”

    interest rates don´t have much room to fall further.
    where do you see the bullets?

  • http://breedinginstability.com Mountaineer

    Jeffrey Lacker

  • hfm

    I have been a big fan of this site since 2009. It was so interesting. The topic was diversified including trading, investing and economy.But recently I found it just became another economy site . Today is a huge day, policy, economy, market,etc. But the market action was not even a topic here.

  • http://onlypricesmatter.wordpress.com/ B Ferro

    Interest rates have nothing to do with anything here.

    Asset prices mean everything.

    Remember, the world remains over-levered.

    In other words, relative to assets, their is too much debt.

    You fix this one of two ways – let the asset side of the ledger fall, thereby creating widespread insolvency after which debts will be written off and restructured a la the 1930s.

    Bernank has told you this is unacceptable.

    Therefore, move on to option #2, which is to simultaneously inflate, carrying asset prices higher and the fixed, nominal levels of debt loads lower.

    Bernanke has now told us for three years this is his chosen path to de-lever.

    Until something stops them, and this is key, they will continue along that path.

    That path has always been excessive inflaiton but even now they’re telling you they’re so fed up with the lack of growth and inflation they they’re willing to see prices rise above 200 bps YoY CPI.

    So…the Fed uses its tools to drive psychology as Bernanke yet again, tells us all the time.

    Asset prices moving higher = self-reinforcing cycle = chosen path of de-leveraging.

  • Gary_UK

    One day in the not too distant future, we will look back and laugh at the dumb way the world reacted to the pointless actions of this bearded fellow and his colleagues.

    He has but one agenda: to prevent debt deflation from destroying the dollar-based system. Nothing more, nothing to do with the economy, nothing to do with growth, nor inflation.

    As debts are destroyed so too is the dollar’s lifeline, so he will continue to create new base money to buy up the decreasing debts.

    Of course the problem with his actions is they damage the dollar’s credibility as a safe stable currency (just look at gold’s move today as evidence).

    The world will continue to turn away from the dollar, and that will force yet more base money creation to buy the debts and fund the deficit and trade gap, and more dollars will try to return to America to be spent before inflation really sets in (as the Chinese are doing with real estate right now).

    The end game approaches folks, if you haven’t realised it yet, you still have time, but not so much.

    Remember, all global reserve currencies age and die, and gold is the best store of wealth through the transition.

  • Mark

    Very helpful. Thanks Cullen.

  • GreenAB

    excellent points by Mark Hanna (hope the link is allowed) on markets psyche:

    http://marketmontage.com/2012/09/13/the-one-downside-of-open-ended-qe/

  • AWF

    This is a muted response from “The Fed”

    Should have gone Much Much bigger on MBS

    “The Fed” wants to sell houses–try 0% interest

    Unlimited QE–how weak knee can he get !

    “The Fed” wants to spur consumption
    Its working–I’m buying all the gold and oil I can

  • Cowpoke

    If fanny and freddy already back 90% of mtgs, why does matter if the fed swaps them for reserves since banks are never really reserve condtrained in the first place?

  • Cesar

    “The end game approaches folks, if you haven’t realised it yet, you still have time, but not so much.”

    If your “end game” ever arrived — which isn’t likely to happen. Then the people with the guns will take the gold from the people without the guns. Good luck in that world. Should be smashing fun for all.

  • Dunce Cap Aficionado

    I would have sworn they would hold off until after the election…..

  • Dunce Cap Aficionado

    Can one of ya’ll who’s much smarter than me (most of you) explain to me in terms an 8 year old would understand how this torpedos Mitt?

  • Gary_UK

    Not likely, gold owners are a tad more canny than to walk around waving their gold under everyone’s noses. Most keep it very quiet, very safe, and are prepared for whatever short term problems might arise.

    Life will go on, just our views on money will change.

    You will see, it is a mathematical certainty.

  • http://macronomy.blogspot.com/ Martin T

    Thank you Ben for spiking up yet another time commodity prices, that’s exactly what Middle-East needs right now with the on-going unrest…

    Dear Ben, your QE3 will only prove that monetary policy alone cannot prop up the labour market because, dear Ben, banks are still hoarding cash (credit crunch), that’s right, and not lending it…Although you did manage somewhat to trigger inflation expectations upwards. Yep, in normal times this should trigger a credit boom but dear Ben, this is not a normal recession, it is a Balance Sheet Recession.

    You want to start a non-deflationary growth Ben? How about fiscal stimulus before a Japanese style deflation?

    Because dear Ben, decline in wage inflation is a deflationary sign (paradox of thrift).

    Nicolas Doisy from Cheuvreux put it better than me Ben:
    “All in all, the US strategy to exit the current deflation(ary) trap misses the point by focusing only on monetary policy, while a fiscal stimulus is also needed. In other words, labour is insufficiently compensated for the sole reduction in real interest rates to kick start growth. So, either labour is given a larger bargaining power or it must receive massive money transfers to start spending again.”

    So Ben, sorry but it ain’t going to work either this time around.

    Best,

    Martin

  • George H

    One more omnipotence of the Fed, its monopoly of interpretation.

    The Fed explains its own policy (intention) and result (which are outcomes, or facts). Who can argue otherwise?

    For example, Bernanke said the Fed created 2 million jobs. There is no appeal, or even debate for this claim. Any non-believer is irrelevant. So you have to love the Fed.

  • Anonymous

    Bingo to this and Gary below.

  • KH

    Cherry-picking data three hours after the announcement is a fraught exercise. Sumner should have at lest waited for the closing bell.

    10-Year Bond
    1.76
    -0.01
    -0.51%

    Does this mean the policy is already a failure?

  • Cowpoke

    My guess is it spurs the “wealth effect” process by driving markets higher because of false perception of money printing.

    People see the stock markets up and thier 401k’s and they figure they are better off than they were 4 years ago.

    I think…

  • Dunce Cap Aficionado

    That makes sense and all, but if employment doesn’t improve drastically than I don’t think independent voters (who win elections) are going to say, “Holy Sh*t!” in the past two months the stock market went up, we GOTTA relect Obama.

  • http://www.pragcap.com Cullen Roche

    It’s the rebalancing. They reduce the amount of Tsy’s in the market which forces some managers to rebalance. It drives investors up the risk chain. Problem is, it has nothing to do with fundamentals. So it’s exactly as I described – like a company that buys back its stock and never reinvests in the underlying operations. Except this is our govt doing it. Once the govt fiscal gravy train runs dry the pvt sector will be left holding Ben’s bag.

  • beowulf

    As I understand FOMC custom, the six other Fed governors (plus the NY Fed president) always vote with the Chairman. Even if the 4 other Fed bank presidents vote as a bloc, they can never overrule the Chair. I’m not sure if this is because the Chairman’s job is to build consensus or because the other Fed governors feel obligated to back his play, probably a little bit of both.

  • PeterP

    CR,
    Is that a bad thing? If Fed’s credibility is destroyed we move on the what MMT/MR says: do fiscal policy to support deleveraging. Market Monetarism and QE will be shown ineffectual, a very good natural experiment I’d say, no?

  • ES71

    > “All in all, the US strategy to exit the current deflation(ary) trap misses the point by focusing only on monetary policy, while a fiscal stimulus is also needed. In other words, labour is insufficiently compensated for the sole reduction in real interest rates to kick start growth. So, either labour is given a larger bargaining power or it must receive massive money transfers to start spending again.”

    That is eaxctly it. And the “labor” is so mad at this point by always getting the short end of the stick that they keep pitchforks at the read. All they need is a target.

  • Tom

    my humble predictions:
    1. This will only create more uncertainty in the business community given that we are now in uncharted and actually scary territory. Unemployment will remain high if not higher.
    2. Deflation is still coming along with a REALLY bad reccession. After that, severe stagflation.

  • ES71

    > The Fed explains its own policy (intention) and result (which are outcomes, or facts). Who can argue otherwise?

    Lol,sounds like a religion.

  • Dunce Cap Aficionado

    I must be looking at this sideways because I’m still not getting it.

    This hurts Mitt because it will likely lead to rising stock and commodity prices prior to the election which will be preceived by voters as proof of economic improvement? Because, I mean, I have a habit of say most people are dumb (like me)… but are they THAT dumb?

    Follow up- Are we likely to see asset prices rise that substantially over the next 2 months?

  • hangemhi

    “carrying asset prices higher”. B Ferro – are you mainly referring to stocks and commodities, or all assets? I presume housing too? I’m a Realtor in San Francisco – it just occurred to me that our City has just regained a lot of the bubble talk/mentality – recently heard “they’re giving money away free, why not take it?”. Our market is on fire – prices have gone up 10% on average in the past 8 months and 20% to 30% in the highrise sections that were hit especially hard post-bubble. Do you think we’re seeing a re-inflating of both stock and housing bubbles? Is this post 9/11 response and results all over again? It is starting to feel like it to me.

  • http://www.pragcap.com Cullen Roche

    Hi Peter,

    I am not gonna lie. I would not be upset at all if the economy turned south in 2013 and QE was proven as a highly deficient policy. If the economy booms from here everyone will hail BB as a genius and they’ll claim monetary policy saved the day. And that means another decade of hanging our hat on monetary policy. It’s kind of sad to say, but it’s probably in the best interest of the nation if things turn south here and we can then definitively proclaim that QE is a dud. Then we can go ahead and start focusing on fiscal as we should. Unfortunately, it might take a downturn to get us to that realization, which is really sad. If people understood the world as MMTers and MRists do then we’d be implementing fiscal here (and maybe monetary policy as a supplement).

  • http://www.pragcap.com Cullen Roche

    I’m not saying it’s a good thing necessarily. But the sad reality is that people equate a rising stock market with a good economy. They see their 401Ks growing, their ETrade account growing, etc and they say “wow, things must be better”. But most people have no idea that the stock market is nominal wealth that can be completely detached from the actual health of the underlying assets. So here we have a policy that is essentially designed to detach nominal from real with the hope that nominal BECOMES real. Bernanke basically said this in his press conference. I wish I had the quote. It was one of the dumbest things I’ve ever heard him say.

  • Dunce Cap Aficionado

    Thanks. I didn’t mean to infer you thought it was a good or bad thing.

    I’ll never forget the time my educated (not in econ or anything remotely related) friend asked me point blank and without hesitation “Is the stock market our economy?”

  • Humblepie

    Cullen: will the Fed’s $40B/month purchase of MBS provide banks with ‘new’ liquidity to finance home purchases? Perhaps the exercise is not so much trying to drive down mortgage rates to increase affordability, but an attempt to alleviate tight money supply conditions that banks are desperately trying to hide?

  • http://www.pragcap.com Cullen Roche

    Hi Humble,

    No. What the Fed does is swap reserves for MBS. So the net financial assets of the bank stay exactly the same. They lose a risky interest bearing asset and replace it with a low risk low interest asset. Reserves are deposits held at the Fed. They don’t leave the Fed. The banks cannot get rid of reserves. The Fed determines the amount of reserves in the banking system. Further, banks don’t lend out reserves. Banks lend based on their capital position and not their reserve position. Since QE doesn’t alter the net financial assets of the banks it doesn’t change their capital position (at least not meaningfully). So this doesn’t make banks more likely to lend. Hope that helps.

  • Humblepie

    Cullen: Thanks for the explanation. Can you please clarify if this ‘swap’ of reserves for MBS increases the size of the bank’s reserves even though there is no net change in the bank’s financial assets? If it does increase the size of the reserves, then why is it necessary to do so?

  • rhp

    this torpedoing of Romney is all based on the idea that this round of QE WILL float all equities higher for the next two months. meaning your algo should have kicked in to BUY mode with gusto. Are you and everyone else REALLY ready to believe he psychological impact of this will be equal to the first QE’s?
    And what about Greece, Spain, China? Do these have no effect on our markets?
    I don’t know the direction of the markets for the next two months, but if everyone is bullish, then is there a contrarian case to be made??

    rhp

  • Hans

    Hats off to Mountaineer! Thank you!

  • The Undergrad

    His thinking seems quite flawed then, divorcing asset prices from their fundamental value, whatever that is. What happens if/when he fails and inflation expectations are replaced by deflation? Wouldn’t that just make the bust all that much worse?

  • Hans
  • Sean

    Cullen,
    For some reason, I’m still not getting this. If the Treasury issues debt, which the primary dealers bid on and purchase, then the fed swaps these bonds with the PD’s, how is that not akin to monetization? What would be a scenario that could accurately be described as “money printing”? Forgive me if I sound obtuse with this line of questioning.

  • hangemhi

    yes, but that’s what a bubble is. “short” term decoupling from fundamentals. yes, the fall will be worse, but do you really sit out of a bull run because you know that some day over the rainbow people will wake up again? I noticed things getting crazy in my RE market in ’04… and it lasted 4 years. So do you sit on the sideline and sulk? Or do you bite your tounge and try to participate knowing that you’ve got to do it while wearing a parachute?

  • Bruce in New Orleans

    A broken record that is music to my ears! I am finally getting it! lol.

  • jt26

    At least for equities, tt may be more than rebalancing if corporates also relever and buyback shares. Since 2007, SP500 have significantly reduced debt/EBIDTA.

  • rhp

    only true if the MBS par value is equal to market value, which I believe is highly suspect. Are you now assuming that QE-1 took care of all toxic MBS and all the remaining MBS’s are golden?

  • Alberto

    Totally predictable. The problem is: MR may be right but the world is wrong so you have to put your money in the theorically wrong place. Euro is horrible but as I wrote many times in the past all those who short it against the dollar would have been burst. And despite gold is really a barbaric relic it’s a strong buy at least to 2015 when it will probably be over 2300 $. Easy calls.

  • rhp

    oops, shoulda read you more closely and followed your link: “The recent QE’s have had a far more muted effect as these assets are all selling at par or above.”

    sorry, you addressed my concern very clearly earlier in your posting..

    rhp

  • http://www.imf.org/external/pubs/ft/wp/2012/wp12202.pdf REN

    The 100 percent reserve solution resolves the debt crises. Most of the world’s best economists signed off on the plan circa 1935 to 36. The people back then were not dumb, and their findings have been validated. In fact, they appear to have more imagination and understanding than economists today. FDR didn’t put it into law because he was afraid of something (banking hit men perhaps?)

    The real solution is to circular file (that would be trash can to our English friends) the debt money system. I agree it is mathematics when the claims grow exponentially by contract obligations and try to demand from the organic economy. Not to mention that the liabilities always exceed the asset, and the asset amount is the “credit” money level that enters the economy during loan hypothecation. Exogenous Base money has to enter the system otherwise inside bank money (credit)growth means simultaneous debt growth, throwing economies continually into depressions. Some non bank financial actors outside the Reserve system had leverage ratios as high as 40 to 1 during the 90’s bubble.

    The private banking system came into being with fraud, as the Goldmen issued notes in excess of their deposits. So, here we are today, continuing with fraud. Money is a public good, it belongs in the public sphere. The commonwealth is a commons, and money is part of the commons.

    The reserve solution keeps private banks private. Government will only use its knobs to control real money supply volume, similar to some FED actions on Credit money today. The Treasury will be constrained by law, and as well it will be exposed in all of its actions. Can we say that about the FED and private actors? Serious minded public servants will be issuing public money in accordance with the law, or they go to jail. Which system then is more likely to predicate for fraud? Public or Private?

    http://www.imf.org/external/pubs/ft/wp/2012/wp12202.pdf

  • Tom Brown

    Market Monetarists are quite pleased today. They think Bernanke just took a solid step in the right direction:

    http://marketmonetarist.com/

    Check out the links at the bottom as well… Sumner and others are also quite pleased.

    Mish Shedlock, whom I take to be a “realistic” Austrian (if such a thing exists) since he seems to basically believe the MR/MMT/post-Keynesian description of money creation (he just doesn’t agree with it, … preferring “sound money” policy (gold buggery) instead), and because he understands that private debt levels and rampant fraud are big problems (and that hyper-inflation is not), does not seem pleased by Bernanke’s actions:

    http://globaleconomicanalysis.blogspot.com/2012/09/fed-to-increase-mbs-at-pace-of-40.html

  • B Ferro

    Yes I mean all asset prices.

    Bernnke’s commentary here is all we need to worry about.

    And I’m not trying to be a jerk here, but we discuss this over and over and over through the years and yet and still so many (69 commets here on the subject) express great amazement at it..they will not let the asset side of the ledger deflate!

    This doesn’t mean the bubbles that have had their day in the sun are about to have another – once a bubble pops the industry and valuations in it tend to have structural limitations for a decade or more, housing included.

    With respect to your industry, prices, both equities and actual property, had over-shot much too far to the downside vs. other bubble explosions in history and were ripe for upside (and still are). Don’t go thinking its 2005 again and structure your business plans on that mentality though. Enjoy what is likely another one year reprieve. That said, the worst is behnd you.

    In 1996-2000 it was the Greenspan tech bubble. In 2003-2007 it was the Greenspan/Bernanke housing bubble. During QE2 it was the Bernanke commodity bubble (all commodities)…I’m inclined to think that when we look back on this day in history we’ll likely be able to define it as the beginning of the precious metals bubble.

    Though metals have had incredible runs so far over the past decade, so had tech stocks by 1996. The fun got started in the four years after that though and I wouldn’t be surprised to see the same with precious metals from here on on, but most high conviction on gold.

  • joe

    I’m very interested, and confused about the net asset aspect. So when you take a mortgage, the bank increases its liabilities (your deposit) and increases its assets, the loan. No new net assets. Now these loan assets are bundled up together as an MBS. Now if the fed purchases the MBS with reserves, aren’t these reserves nfa’s? Then as the payments are made on the mortgages, reserves get transferred back to the fed through the payments system since the fed owns the bonds, right??? Any help clearing up the exactly flows of asset would be greatly appreciated.

  • http://www.pragcap.com Cullen Roche

    It’s a swap, $ for $. The banks gets reserves in the amount of the MBS. Reserves are an asset for the bank. All they do is swap MBS for reserves. Banks lose the interest from MBS. Govt gains the interest (well, technically, MBS minus int on reserves paid).

  • joe

    Yes I get that, but as the mortgage payments are made, the homeowner’s deposit goes down, their banks reserves balance go down, and reserves are transferred to the fed. Since the mortgage wasn’t a net asset to begin with (deposit/loan offsetting), how can swapping it for reserves not be adding new nfa’s? (I’m not trying to be argumentative, I’m just trying to understand)

  • http://www.pragcap.com Cullen Roche

    The Fed is just getting the interest payments as the mtg is paid down (just like the banks would have). Actually, they get sent to Tsy at year-end.

    Loans create deposits. Paying back loans destroys deposits. The net result is the bank ends up with the interest (assuming full loan repayment). In this case, the Fed gets the interest.

    I gotta run out for a while. Hope that helps.

  • Andrew P

    My understanding is that the Chinese and Hedge Funds also hold a lot of Fannie/Freddie bonds. Aren’t “Agency Bonds” (F/F) the only MBS the Fed can legally buy?

    Maybe the Fed needs to cash out the Chinese holdings of F/F bonds, just in case an (unlikely) Romney Administration decides to let F/F go BK and disappear. After all, if China loses a trillion dollars on F/F, they might do something really nasty like invade Taiwan or launch a nuclear war.

  • Andrew P

    The Fed still has 2 rockets left in their bazooka. They can drop IOR to zero (or negative) and they can print money to buy gold.

  • http://joofie.com yourejammingmeup

    Equities about to explode upwards. Rich people in the market get richer, poor, what’s left of the middle, and labor get the shaft, even though they will look on and see a rising stock market and take it as a sign of economic rebound. The oligarchy controls the money supply indefinitely, wonder how much longer this goes on until people realize what’s up – my guess is never.

  • http://joofie.com yourejammingmeup

    of course this is only an opinion and should not be construed as any advice whatsoever :)

  • Charles

    Exactly. What happens the next time the market has a swoon? No more rumors from a major news agency or CNBC about imminent QE since it will be permanent QE. I guess they will have to rumor mong about the ECB doing a new program now everytime the market falls 5%+!

  • Andrew P

    If the Fed set mortgage rates at a very negative number (like -10%), an awful lot of extra people could afford to buy houses. That is until the negative interest shrinks the economy and the wages of the borrowers faster than the real gains from negative rates.

  • Andrew P

    How is Bernanke brave? I don’t see it. Bernanke will take flak no matter what he does. QE i helps Obama get reelected. Romney has already promised never to reappoint Bernanke. So how is Bernanke taking any “brave” risks by announcing QEi ? He is doing everything in his power to save his own job, by inflating stocks and house prices so that Obama keeps his job. The brave thing would be to do exactly the opposite – to announce an end to Fed asset buying.

  • Paul

    Cullen,
    I appreciate your assessment of the Fed’s use of QE, but your recommendation of setting “long rates at 0.5-1.0% and leaving purchases open-ended”, would be a complete disaster. First, the underfunded nature of pensions would explode higher, for it would be impossible to match liabilities with assets either by mandate or on a risk-adjusted basis. Second, insurance costs would skyrocket, or, companies would just walk away, causing individuals to self-insure. I ask you, how can an individual manage the risk that an aleatory contract provides, when insurance companies cannot match assets with liabilities on a risk adjusted basis in a ZIRP, that extends in to perpetuity? The FED announcement of a ZIRP of 2015 and most likely beyond is and will cause a negative feedback loop, the likes of one we have never seen before. I wonder if you have tried to quantify the negative impact to interest income by savings, for each dollar the FED uses in QE. As always, thank you for your work.

  • Andrew P

    Ben must figure that he can keep the S&P rising for 2 more months. An extra $40B per month taken out of MBS has to go somewhere, and the only places to go are Stocks, Gold, and Corporate Bonds. Former MBS holders certainly aren’t going to invest in Tsy’s at 0% yield.

  • Andrew P

    Sure, banks in aggregate cannot reduce their total reserves, but if every bank is furiously working to invest its excess reserves in something that earns income (like stocks, mortgages, munis, or corporate bonds), won’t that make the money circulate faster?

  • Hans

    Your opinion, is fact, Jammingmeup!
    You are a very wise man, indeed.

    http://www.bbc.co.uk/news/business-19356665

  • Chekhov

    I largely agree with your interpretation of the transmission mechanisms of monetary policy, but I’d like to offer some food for thought. Or, why I’m substantially more optimistic about the Fed statement than you:
    1) The Fed is directly targeting long yields (well okay intermediate and indirectly longer-term). That’s the whole point of saying interest rates will be essentially 0-0.25% until 2015. It’s almost equivalent to saying “We’re setting the rate on all Treasuries maturing before and up to July 2015 to a 0-0.25% yield. And we’ll honor that price until they mature.” This really is the only way for the Fed to target long(ish) yields. In any other direct targeting scheme, if there was any substantial risk that the Fed would increase the overnight rate before maturity, the private sector would avoid such Treasuries. Why? because they could do strictly better by holding and rolling over the shortest term T-bills. The Fed would have to buy up the nearly all of the relevant longer duration treasuries (to honor the unjustified price), which would wreak havoc on the financial system.

    2) Something like a wealth effect is clearly real, at least if you believe we’re in a balance sheet recession. I agree with you and cringe at the idea of inducing people to pay more than the present value of future cash flows for an asset. But I believe the Fed’s idea is not to get people to overpay for the asset but to boost the present value of the asset itself. And the Fed is rightly focusing more on housing than on the stock market.

  • Dr. Oliver Strebel

    Cullen Roche: “Now the Fed is at risk of having the tide come in and everyone realizing they’re swimming naked. They’ve essentially bought high with the S&P trading near its all-time highs. So an economic downdraft and a subsequent market decline has the potential to severely damage the impact of future Fed policy. I personally would have held off entirely.”

    Great comment on the Fed!

  • http://www.worldcpa.com alan

    You should realize that the Fed’s action confirms everyone’s belief that the Fed is intent on destroying the value of the dollar in its quest to stop deflation. Therefore, everyone is trying to protect themselves from the decline in the dollar by buying gold, foreign currencies, and stocks and paying off debt. So the Fed’s actions are actually making things worse.

    The Democrats are intent on borrowing, taxing, and spending, so people see debt accumulating to the point that default is inevitable. As people have less and less trust in the government both on the spending side (Congress) and the dollar side (the Fed), they save more, reduce their debt, and hunker down for the storm. Combine all of this with the decline in demand because of demographics, and you have an economy in Depression.

  • John

    QE3 will demonstrate that the Fed’s attempts to create a robust economic recovery was a failure. Public debt to GDP is 105% and climbing. Household income is falling. 80M Baby Boomers are headed into retirement and creating a consumer spending downdraft. This is the perfect storm.

  • Gary_UK

    Better option is just to give bankers some serious competition, in the form of a stable wealth asset that values currencies in a stable manner.

    It’s known as freegold, hit google and dive in!

  • Tyler

    So lower interest rates don’t aid in the funding of the government?

  • Thomas

    I have disagreed with some of your views in the past, but I think you are spot on on your critique of QE3 and its real mechanism – very good article, a must read.

    While I think that you probably don’t want to take the issue to the controversial side, I need to mention the very real possibility that Bernanke effectively made a backdoor bailout of European banks with QE3, via primary dealers (european ones, including “taunus”, DBs subsidiary, and the french banks).

    Recall that france’s gov’t mortgage lender was nationalized recently, with nary a word in the media and no spike in european bank liquidity measures such as euro basis swaps – full manipulation.

    The problem in Europe is much worse than it currently is being sold to us, I suspect. From here until Obama’s election, it would have been difficult to justify QE closer to elections, it had to be done now. The problems in Europe require ever increasing Dollar funding for banks and the current “invisible” arrangements to provide that funding were probably becoming insufficient.

    Bernanke would never be as naive to waste a bullet under the current US employment and inflation figures, not to mention the horrible timing. It is in contradiction to his “market floor” psychology and effective use of the media to set monetary policy – he is now very exposed and his arsenal is clearly less impressive in the eyes of the players as he has shown his ace.

  • Mikael Olsson

    Why is a depreciated USD bad?

  • Mikael Olsson

    Cullen,

    I would love you long time if you added RSS feeds for the comments sections. Or used DISQUS.

  • Mikael Olsson

    Sigh, mispost. I also wouldn’t mind an edit button – something that DISQUS provides.