Many myths are still floating around regarding the actual operational aspects and impacts of quantitative easing, also known as permanent open market operations.  This primer will offer a series of articles that give the reader better insights as to the actual impacts of the program and how it works.

“Quantitative Easing” (QE) is a form of open market operations that helps the Federal Reserve achieve its policy targets.  For odd reasons, this program has garnered a specific mythical prominence in the media and in the investment universe.   The truth, however, is that QE involves open market operations no different from the way the Federal Reserve always achieves its policy targets.  When you hear that the Federal Reserve is changing their target interest rate this will generally involve open market operations that alter reserves in the banking system in order to achieve this rate.  QE involves permanent open market operations, which deviate from standard policy in that they tend to purchase varying assets from the private sector.  The NY Fed elaborates:

“The purchase or sale of Treasury securities on an outright basis adds or drains reserves available in the banking system. Such transactions are arranged on a routine basis to offset other changes in the Federal Reserve’s balance sheet in conjunction with efforts to maintain conditions in the market for reserves consistent with the federal funds target rate set by the Federal Open Market Committee (FOMC).”

Open Market Operations always involve altering the outstanding reserves in the banking system in order to help achieve a target interest rate.  QE is not unique in this regard although it is believed to have some sort of mythical powers that extend beyond standard open market operations.  This is largely due to poor reporting in the media and a general misunderstanding of the way QE impacts the banking system and the economy.  Many people claim that QE can achieve its goals in ways that are different from standard monetary policy such as influencing demand for loans, portfolio rebalancing, the wealth effect, interest rate channels and other impacts on the economy.   Much of the misunderstanding is also due to the myth that QE helps to fund the US government or is equivalent to “money printing”.  This is far from true.

The truth is that permanent open market operations merely change the composition of outstanding private sector assets and serve no role in helping to fund the US government.  Like all open market operations, QE involves altering reserve balances in the banking system and does not add net new financial assets to the private sector.  Some basic elements discussed below include:

• Because the USA is sovereign in the US Dollar, there is no such thing as “funding” the spending of the government.  Therefore, there is no such thing as the Federal Reserve being able to “fund” the US Treasury.  See this article for more.
• QE is not “money printing”.
• Banks never lend reserves.  Loans create deposits.  The money multiplier is a myth.  This is why QE1 and QE2 did not cause a surge in loans or inflation.
• The wealth effect in equities is a myth.
• The portfolio rebalancing effect of QE can cause substantial disequilibrium in the economy.
• QE does not alter the number of net financial assets outstanding in the private sector.

For details on how QE works, what its impact is and why the policy fails to generate positive economic effects please refer to my archived research*:

Understanding the basics of QE:

The mechanics of a QE transaction.

QE is not “money printing”

The Fed does not “print money”. They exchange assets with the private sector via open market operations. This is a pure interest rate setting operation and not a “funding” operation.

Quantitative Easing – the greatest monetary non-event.

A visual guide to endogenous money and the failure of QE.

The failure of QE2:

QE3 – Another monetary non-event?

Did QE2 do more harm than good?

QE2 failed to control interest rates because it was about size and not price.

The Fed controls rates via their monopoly control of reserves. The myth of bond vigilantes does not apply to the USA.

Misunderstanding the operational aspects of QE can be bad for your portfolio.

QE doesn’t add “liquidity” to the economy or the markets.

QE does not create more borrowing in the private sector.

Policy Mistakes and Misunderstandings:

QE is not “debt monetization”

QE1 and QE2 did not cause an explosion in the money supply.

How QE1 helped the economy due to the extraordinary circumstances (scroll down).

Milton Friedman misunderstood QE.

Bill Clinton was afraid to pay off the national debt.  

Fed officials misunderstood QE.

There is no such thing as an equity market “wealth effect”.

How QE leads to market disequilibrium

Permanent open market operations can influence psychological channels through a portfolio rebalancing effect leading to temporary market dislocations.

The negative effect of QE2 on commodity prices.

Misunderstanding the effects of QE2 was an enormous economic blunder.

* These articles will be better understood if the reader first understands this research paper on understanding the modern monetary system.