The Fed: Still Not Monetizing the Debt

Following QE2 I wrote a controversial piece that argued the Fed was not monetizing the debt.  The purpose of the article was to show how the Fed was not increasing the net financial assets via QE or enabling the government’s fiscal policies.  My argument was rather simple:

1)  QE involves swapping reserves for bonds which results in no change in the private sector’s net financial assets.  It merely changes the COMPOSITION of assets.

2)  Monetizing the debt implies that there is not enough demand for government bonds and that the Fed needs to backstop the market for government bonds.  This can’t be true though because the Primary Dealers are required to bid at auctions and would only reject this mandated duty in case of a hyperinflation where it became unaffordable for them to serve as the government’s funding agent.   (This doesn’t mean inflation couldn’t result in currency and bond rejection!).

So I was extremely pleased to see Bernanke say the following this morning:

“By buying securities, are you “monetizing the debt”–printing money for the government to use–and will that inevitably lead to higher inflation? No, that’s not what is happening, and that will not happen. Monetizing the debt means using money creation as a permanent source of financing for government spending. In contrast, we are acquiring Treasury securities on the open market and only on a temporary basis, with the goal of supporting the economic recovery through lower interest rates. At the appropriate time, the Federal Reserve will gradually sell these securities or let them mature, as needed, to return its balance sheet to a more normal size. Moreover, the way the Fed finances its securities purchases is by creating reserves in the banking system. Increased bank reserves held at the Fed don’t necessarily translate into more money or cash in circulation, and, indeed, broad measures of the supply of money have not grown especially quickly, on balance, over the past few years.” (emphasis added)

Dr. Bernanke’s always understood this.  The general public has gotten this colossally wrong though….For more on QE please see the understanding QE section on the site.

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. I’m confused. This sounds like a case of a bunch of learned economists all with their own motives and vastly different expectations for the same complex actions? Seems like I can bet on no one knowing what will happen, except I can follow the long term fiat trend of devaluation, asset/commodity price rising (but maybe not real prices) and perhaps another real estate bubble. Are we arguing over how much inflation Fed actions will result in? Or the definition of inflation vs. disinflation; CPI vs. other measures; money supply vs. price trends?

    Is the point here that Krugman things Ben should do more to create actual significant inflation?

    From Krugman:
    “I’m a bit puzzled by the tone of this FT report on how QE3 is doing so far, US inflation fears rise after QE3, which seems to imply that a rise in breakeven rates — the difference between the interest rate on ordinary bonds and inflation-protected bonds — is a danger sign. (Breakeven rates are a simple gauge of expected inflation).

    On the contrary, it’s the whole point of the exercise. For almost fifteen years, some of us have argued that central banks can gain traction even in a liquidity trap if they can create expectations that money will remain loose after the economy recovers, generating modestly higher inflation. And that’s what the Fed’s new tack is supposed to achieve.”

  2. As far as I recall, this all comes down to what the commercial banks choose to do, do they spent the excess reserves they acquire via the fed’s actions? Are you just saying the Fed won’t let this money be dumped into general circulation, thereby causing much higher inflation?

    • Arnold,

      Banks don’t spend reserves. Reserves are deposits in the interbank system used ONLY for settling payments and meeting reserve requirements. They don’t get spent into the economy. And they don’t get loaned out either….

      • OK, that may be true but then it is simply correlated with what can be lent out, since it is a reserve serving as collateral for loans, no? An increase in reserves could allow banks to increase lending?

        • Banks are constrained by their capital. Not by their reserves. Reserves are merely an asset. When a bank makes a loan it finds reserves AFTER the fact if necessary. QE does not change the net financial asset position of a bank (bonds, an asset of the bank get swapped for reserves). Therefore, it does not make it more or less capable of making loans.

          • Cullen, How could one best relate in layman’s terms the social value comparison of Reserves being an asset?

            For example, A home, a motorcycle a boat a gold krugerrand could be considered assets. However, they all have varying value daily with regards to their meaning/term asset with regards to the amount of inside money they can be exchanged for. Do Reserves have the same amount of fluctuations/ constraints?

            • Think of reserves as cash held on deposit at Fed banks for use in the interbank market. They don’t leave this market and they serve only to settle payments and meet reserve requirements.

          • When is it necessary? When they are highly leveraged to begin with and approaching imposed (self or regulatory) fractional reserve limits? I don’t see how it matters whether it needs to find reserves to cover a loan after or before. What happens if they can’t find reserves? Presumably it must curtail loaning? If it is pumped up with reserves, it could, if it chooses, loan more? What am I missing?

            • In other words if it has been lending previously seeking now gotten reserves from the Fed, why wouldn’t it play the game again to entice further reserves from the Fed? Is the commercial banking cartel that afraid of market discipline after round after round of bailouts?

              • Arnold,

                It helps to think of the banking system as a single large bank. When this ‘bank’ makes a loan, it creates and credits new credit/debt ‘money’ to a new account (a liability, with a new ‘loan receivable’ as the corresponding asset). It doesn’t have to ‘cover the loan’ since the new ‘money’ exists and stays at this ‘bank’ (nobody takes out a loan in order to covert it to cash to keep under their mattress).

                In reality, the borrower (or the seller of a house or car to him) might deposit the funds at a different bank from the one that made the loan, forcing the latter to make a ‘payment’ to the former, but through the interbank lending system, it could borrow reserves from the former to cover this payment. Reserves are there to cover payments, not loans. If necessary the Fed can be relied on to provide additional reserves to keep the payment system working – on a massive scale if necessary, in the event of crisis, mass defaults, etc, causing interbank lending to freeze up, as it did in the fall of ’08.

                This fact – that the ability of the banking system to create new ‘money’ by lending – is not ‘reserve constrained’ – is what has led me to ask if there is any practical measure that could limit such lending by the system as a whole, eg to some ratio of base money/NFA (Net Financial Assets). Others favor something like the ‘Chicago Plan’ based on ’100% reserve’ banking.

  3. Sorry for 3 comments in a row. I understand the US can’t technically go bankrup, not sure anyone is really arguing that it can technically. I’ve always thought the real fear is if belief in the monetary system itself. Sure the Fed can create whatever money it wants and the Fed government can create whatever laws it wants. The amount of QE is like the lack of the emperor’s clothes… at some point people will start to recognize that he is naked, and then his fairy tale rule will dissolve. At that point people will look to get out of the dollar. What am I missing?

  4. Hello Cullen,

    QE does not monetize but QE can create specific assets bubbles.
    Could this end up having some inflationary impact on aggregate demand, say if holders of stocks were to cash in their profits ? Or would that be compensated by holders of annuities that are loosing when interest rates fall ?

    Thank you !

  5. QE may not be directly change a bank’s balance sheet since a bank gives up one asset( Treasury bonds) for another ( cash reserves sitting at the Fed) but that action is at the bank side not the Fed Side and the discussion that the Fed is not monetizing or printing isn’t discussing how the Fed accounts for it’s side of the equation. The Fed is now holds an unprecedented amount of debt. And banks don’t have to keep commit that Free up Treasury bond or MBS as cash, but can purchase commodities, Swaps CLOs etc. The Fed’s QE move may not be able to increase bank lending, but it can increase the amount of cash floating around, since it’s Treasury bonds and Taxes that sop up liquidity.

  6. An additional question on this point: what about the purchases of 40 billion of MBS a month being implemented indefinitely by the Federal Reserve. Is this a first step towards a solution to the consumer balance sheet recession? Would you recommend an extension of this program and have the fed purchase a higher volume MBS securities to bring relief to the large portion of underwater home owners in the U.S. How about expanding this program to auto loans, student loans, and other unpayable debts in the financial system? Is it possible to QE all outstanding private sector debt in the hope of stoking the flames of consumer demand?