Understanding Quantitative Easing
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.
To better understand this it’s easiest to condense the accounting into the two basic ways in which QE transactions occur. The first scenario is when a bank sells t-bonds to the Fed. The second scenario is when a non-bank sells the t-bond and the bank merely acts as an intermediary. In both cases the private sector has the same net financial assets before and after QE occurs. So it’s best to think of QE as an asset swap that alters the composition of the private sector’s financial assets, but does not ADD net financial assets.
Scenario 1 – Bank sells $100 in t-bonds to Fed
Federal Reserve balance sheet:
Change in Assets = +$100
Change in Liabilities = +$100
Change in Net Worth = $0Banks balance sheet:
Change in Assets = $0 (t-bond is swapped for reserves)
Change in Liabilities = $0
Change in Net Worth = $0Scenario 2 – Non-bank sells $100 in t-bonds to Fed where bank acts as intermediary
Federal Reserve balance sheet:
Change in Assets = +$100
Change in Liabilities = +$100
Change in Net Worth = $0Banks balance sheet:
Change in Assets = +$100 (reserve assets increase)
Change in Liabilities = +$100 (deposit liabilities increase)
Change in Net Worth = $0Non-bank public balance sheet:
Change in Assets = $0 (non-bank sells t-bond and obtains deposit)
Change in Liabilities = $0
Change in Net Worth = $0
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. It’s true that the government could use the Fed to fund the US Treasury’s spending, but that would involve a full blown rejection of bonds by the Primary Dealers. In other words, the only time the Fed would be required to purchase bonds in a funding short-fall is in the case where the Primary Dealers reject their mandate to purchase bonds and the Fed must fill the void. Clearly, given record high bond prices, tanking yields and very strong demand at all auctions, the evidence that this is occurring is weak to say the least.
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 an autonomous currency issuer, there is no such thing as the USA being able to “run out” of money. The idea of QE “funding” the US Treasury would mean that demand for US debt has dried up. That’s very clearly not true. See this article for more.
- QE in Europe can actually “work” because it is essentially a form of fiscal policy that actually helps to fund the countries in Europe (or at least help them avoid losing funding). This would be like the Federal Reserve buying municipal bonds from states in distress who can’t find Federal funding (this would essentially be a form of fiscal policy and would be “money printing”).
- QE in the form of buying back government debt is not “money printing” or “monetizing the debt”. Importantly, it does not directly increase the supply of “inside money”, the most important form of money in our economy (see here). It is a swap or a change in the composition of private sector financial assets. No net new financial assets are being added. The private sector gets reserves, the Fed takes the bonds. The net loss is in the difference in interest income. But the private sector is not left with “more money”.
- Banks never lend reserves so more reserves don’t mean more lending. 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 flaw in QE is that it reduces the number of specific securities so it can force investors out of one asset and into another. This can drive up prices, but does not necessarily drive up the fundamentals. It’s not unlike a stock buyback and its immediate effects which drive up price, but have no impact on the underlying corporation.
- The portfolio rebalancing effect of QE can cause substantial disequilibrium in the economy. We saw this in QE2 when I repeatedly predicted that QE was causing an imbalance in bond and commodity prices. And when the air came out of that 2010 nearly turned into a nightmare….
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.
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.
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:
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
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.
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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