Why QE is not Working….
That was the headline at Zero Hedge yesterday. I won’t opine on their analysis, but I will just say this: the reason why QE doesn’t work as it’s being implemented is because the transmission mechanism is entirely flawed. Why is this? I explained this years ago, but a more succinct answer will suffice.
The way QE works is just like all monetary policy. The Fed alters the amount of reserves in the banking system and alters the demand for credit. But the big difference between altering the Fed Funds Rate and implementing QE is that they manipulate prices in setting the FFR. That is, the Fed sets the price of overnight loans by SPECIFICALLY naming the price of the loans. This has a dramatic impact on the banking system and the profitability of loans. But QE has been implemented in an entirely different manner. It’s been enacted not by setting a price, but by naming a quantity (like, “we’re buying back $600B of US t-bonds”). So the effect is that banks sell bonds in exchange for reserves, interest rates aren’t altered all that much and the private sector ends up with little change to its balance sheets (QE is a simple swap of assets that doesn’t alter the net financial assets of the private sector).
And because QE works primarily through the lending channels (as monetary policy always does) it hasn’t had much of an impact. There are a few other side effects of QE (like portfolio rebalancing, wealth effects and mythical psychological effects on economic actors), but the big factor is that it doesn’t induce more lending (because it doesn’t have a transmission mechanism through which it makes credit more attractive – not to mention, in a balance sheet recession, consumers are already shunning credit), but it also doesn’t alter the net financial assets of the private sector. So the net result – QE just doesn’t do much. It is, as I said many years ago, “the great monetary non-event”.
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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49 Comments
Could they create a new class of reserves called Q.E. reserves and they can be used for loans after a certain time period?
Yeah it doesn’t help that regulators are raising capital requirements on banks at the same time. Government is essentially giving with one hand and taking with the other hand.
I’d say QE has worked extremely well for what it is intended for. The stock market is near a high and people aren’t feeling too bad. It’s made people cut loose a little more with a dollar. This economy is heavily dependent on an advancing stock market for better or worse.
Bernanke has reversed two major selloffs and currently has investors feeling pretty good about things. He’s even going to get Obama re-elected.
As a person who primarily invests in bonds and a non-believer in the future of the market, he’s caused me no end of aggravation. However, I think what he has done is probably pretty smart. He’s floated a burned out economy and that’s doing something.
This is basically what I came here to post. I remember reading that the Fed said they were hoping to inflate asset prices. Basically meta-medication to boost confidence from the higher prices and encourage risk-taking because of the lower yields, etc.
QE has worked so well we’ve gotten to the point they don’t need to do anything. There’s no point in a selloff, because the Fed will step in. Obviously is has limited ability to actually increase demand, but for what the Fed is able to do, they’ve done a bang-up job.
It’s flawed economic thinking to target nominal wealth. Stock prices are not real wealth until realized gains are taken. Of course, everyone can’t cash out of a stock market at once and realize the gains. More importantly, stocks are based on the underlying value of the assets they represent. Pushing stock prices up does not make the companies more profitable. So hoping that people will spend more of their current income because of a false price appreciation in the market is a misguided policy. This is one of the main reasons why the Bernanke Put has perpetually failed to sustain price gains. Policy should focus on improving the balance sheets of the underlying assets. Not propping up nominal prices.
Cullen,
I know you have said that QE does not have a lasting effect and it is simply an asset swap. When the PD exchanges their bonds for reserves that most likely pay less interest, what choices do the PD have to redeploy these reserves? Is the only option for these reserves to be used in the settlement process after loans are made. These reserves can’t be used to buy commodities directly or stocks directly? How then does the price of commodities go up or the price of stocks go up?
Is it still some mistaken understanding by market participants or a well planned / orchestrated behavioural experiment by the FRB using carefully chosen media and spokespersons that guide towards the desired outcome?
The Fed removes Tsy bonds from the market. This forces many portfolio managers to reallocate to make up for the lost bond allocation. This can have a positive rebalancing impact on certain assets. Reserves are bank money. They do not get “used” to buy other things. They’re used in the interbank market for settlement and meeting requirements. That’s all. Most important factor here is that bank balance sheets aren’t altered. NFA doesn’t change. So a bank that wanted to buy stocks (on margin for instance) still has the same balance sheet position with the bond or the reserve. Nothing has changed in terms of their capital position.
Geez, it’s kind of hard to say QE has failed to sustain asset prices when we are trading at S&P 1414 and look to be headed higher.
QE is not intended as a policy to turnaround the economy. It is a band-aid intended to help the economy somewhat. Only effective government action can improve the economy or wait for it to recover on its own.
The Fed is doing what it can do and what it has done seems far more effective than ineffective.
If the market were trading at 1150, we’d see a lot more corporate and individual retrenchment.
I’ve said it before and I’ll say it again, financial assets aren’t the only ones to benefit from QE. In the real world, falling raw material prices causes destocking and makes for some serious whipsawing in business conditions. The effect has dampened since ’09, as no one carries the amount of inventory they used to, but it still happens.
The Federal Reserve needs to force the leverage out of the market.
I agree with Wells Fargo Must Die’s assessment. If a primary goal was to raise equity prices…then QE can be considered a success. And if you think that QE is propping up equity prices–like I do–you’ll have to position your investment portfolio around a possible disappointment in September.
I wrote about this in a blog post this morning: http://jcinvests.wordpress.com/2012/08/16/why-does-the-market-continue-to-rally/
one acute concern i would have as an investment manager is that Bernanke has effectively obliterated the short seller (or long short fund manager). Which means that if we get an aggressive selloff in the stock market for whatever reason, be it Europe or fiscal cliff, that there will be no back bid in the market. Shorts keep the market honest and banning short sales (or effectively doing so in this case) has met with disasterous consequences in the past, particularly in Europe. If Europe is the equivalent of the Reimann equation i.e. unsolveable, which it is then i genuinely fear for the stock market in general.
Not to worry. If needed, the Fed will buy stocks. The Fed need only to float that rumor and the downturn will reverse. When the Fed cannot manipulate the market upward, it’s the end of the world as we know it. But we will not feel fine like REM.
Do we know for sure that the Fed was crediting bank reserve accounts as opposed to private bank accounts? From whom did the Fed buy back the majority of the bonds?
I understand that a retiree swapping his T-bond in for cash didn’t gain any new financial assets; for all intents and purposes, his assets/liquidity remained unchanged.
However, I’d make the argument that there’s a significantly larger psychological impact to crediting personal bank accounts with fabricated cash vs. crediting a bank’s reserve account (which is conceptually similar to burying the cash in dark hole somewhere).
The Fed ALWAYS implements policy by buying assets from banks. They do not buy from private investors. Even if they did there would be no balance sheet impact. So let’s say you sell your Tsy to a bank who then sells to the fed. Do you have more purchasing power than you did before? No. Perhaps you’re more likely to go buy another asset to replace this lost income stream, but you’re not more inclined to spend sustainably because your balance sheet hasn’t actually changed at all. Your net worth is precisely the same as it was before….
It sounds like a dollar is created in there somewhere.
I buy a Treasury for a dollar. (I have traded an asset for an asset so my net worth is the same.)
However, the Fed spends my dollar, which is new money.
I used to think the Fed was obligated to pay back the loan, maybe with tax dollars. But the Fed here buys the Treasury out of reserves.
Now does doing that create issues down the road? I don’t know. Theoretically, could the Fed buy all kinds of things out of reserves?
The Fed does not “spend” the t-bond. It holds it on its books and the interest earned on it actually reduces the govt deficit. If anything, this reduces the flow of dollars back into the system by virtue of reducing the deficit.
One could say this is a form of monetization (allowing the govt to spend in the future), but this is wrong. That assumes there is not enough demand for t-bonds at auction. Which is nonsense because the PD’s are required to bid at auction.
Oops, so the Defense Dept spends the dollar. Or the Social Security administration.
Big picture:
a) I had a dollar.
b) I exchanged that dollar for a Treasury.
c) Sombody got a dollar’s worth of government services.
A dollar has been created, right?
When the govt spends they take $ from someone and respend it into the economy on something for public purpose. This is achieved by taxing or selling bonds. When they tax they are literally just redistributing existing money. When they sell deficit spend (spending in excess of tax receipts) they are not only redistributing funds from the bond buyer to the spending recipient, but they are issuing a new financial asset to the bond buyer. This increases net financial assets.
QE is totally separate from the above process. When QE is implemented the Fed buys a bond from a bank and credits their reserve account. No change in NFA, no change in govt spending.
Yes, I see that.
Spending tax money redistrubutes the asset.
Deficit spending creates a new asset.
To Cullen’s point here. In a simple English: a guy buys a $1 T-bond, then Fed with QE gives that $1 to that guy back, then Fed holds that T-bond till maturity, on maturity US Gvt and Fed just clap right and left hands and shred the T-bond.
So, NO new $1 has been created during QE here, neither from thin air nor from bull fart. A simple asset SWAP, something like moving $1 from a money market/saving account to a checking account.
Lol.
You wrote: ‘In a simple English: a guy buys a $1 T-bond, then Fed with QE gives that $1 to that guy back, then Fed holds that T-bond till maturity, on maturity US Gvt and Fed just clap right and left hands and shred the T-bond.’
How about I make it even simpler for you? Take your ‘guy’ out of the equation, and you then have the real reason for QE.
The Fed creates $1 via QE and buys a $1 treasury.
It’s called debasing the currency, monetising the debt, funding a profligate govt by creating currency from thin air.
Simple, so easy to understand.
And no one here EVER answers the obvious question:
Where did the Fed get its $1 from? ……??
Answer: thin air, created by monetary magic only available to weak-willed governments with compliant central banks.
Come on Gary. Inflation is 1.7%. There is no inflation, no hyperinflation coming as you predicted. You all have been wrong for years and years. You’ve based your inflation thinking on a misunderstanding of the way the monetary system works. You were wrong. Why don’t you at least try to understand why you were wrong?
Actually the Gvt or Congress, to be precise, can create a new $1 with a deficit spending, which is fiscal policy. Fed can only use monetary actions to add or remove liquidity at the market place, and that liquidity operations are based on already existing $. Fed does not by TSY directly from the Gvt, it buys it at the secondary market via its Primary Dealers. So, when Fed buys bonds it simply gives those $$$ back to those that already had them on the first place before buying T-bonds. It could be even called “premature maturity”
Storing freshly “created” money in a vault where nobody can get to it isn’t the same as handing it out to passersby on street corners.
How exactly does inflation (let alone hyperinflation) ensue if the Fed’s only crediting reserve accounts?
Oops, Gary said the same thing below, but what the heck …
In your example, the Fed buys the bond back for a $1. But where does it get that money?
At some point the debt was monetized, either in the beginning when the government spends the money that went into the bond, or at this point.
I wish the MMR would concede that money is being created out of thin air by deficit spending. Go ahead and argue that it won’t matter, but admit that we’re monetizing, please.
It’s not monetization. I’ve explained this to you several times already. Monetization implies a lack of demand. The Fed buys on the primary market. The auctions go off fine whether the Fed buys on the secondary market or not. Check the data when QE stopped.
Deficit spending creates NFA. QE is a swap of reserves for t-bonds. No change in NFA. One is monetary policy, the other is fiscal policy. You’re confusing the two.
Oh, and it Monetary Realism. One M = MR.
I give the government a dollar and they give me a piece of paper worth one dollar. Then they spend my dollar.
End result: I still have my dollar (in a different form), but somebody else now has a dollar, too.
Your words: ‘This increases net financial assets. ‘
The only way that this is *not* monetization is if the government someday takes a dollar from someone else to take back my piece of paper and destroy it. From what I can gather here, that will never happen.
Johnny,
This is silly word play. Yes deficit spending creates money, what Cullen calls “outside” money. And note in your example that you said “you” gave the government a dollar. You are not the Fed, you do not have an unlimited amount of reserves. You gave the government a dollar because of your savings desires, not because you really liked that government spending it was going to go to.
As Cullen has said, monetizing debt implies the Fed buys the bonds directly from the Treasury because the Treasury can’t sell them to Primary Dealers. So, in order to make sure Treasury checks clear, the Fed would have to credit the Treasury account in exchange for the Treasury bond. That is not happening here.
I suppose it is a matter of definition. When I say monetization, I say it’s because money is being created and spent. And that is happening in our system.
In theory, that’s inflationary. As has been said here, that has not happened, although we can argue that we’ve seen inflation in real estate, commodities, things of that type.
…
Also, I am giving the government a dollar for a bond for the interest and because I believe that at some point I believe the government will have to give the principal back to me.
A financial asset, the bond, is being created. Your dollar is simply transferred. You bought the bond because you decided to forgo spending that dollar to today in order to spend it tomorrow with the few extra dollars you earn in interest, that’s your savings desire. That dollar plus interest will be paid back to you in the future simply as another transfer, whether it be tax receipts or funds from future bond sales that create new net financial assets. Do you see why MR/MMT says the government’s debt is the private sector’s savings?
PS – Is it too much to ask you for a little help with the Cubs? Maybe call in a few favors with the baseball gods up there? It’s been too long.
Unless you consider t-bonds to be “money” then you’re not correct. T-bonds to me, are money-like, but have a much lower level of moneyness than something like cash notes or coins. But this “money” is being created in the deficit spending process and has nothing to do with QE. The deficit spending happens WITH or WITHOUT QE. This is the distinction you aren’t making. Most of the money created in our economy is created by private banks. Not the govt.
We’re talking about two separate things. You were referring to QE. I am referring to deficit spending. The deficit spending happens whether QE is implemented or not. It doesn’t enable the deficit spending. Plus, you don’t get an increase in dollars via deficit spending. You get an increase in t-bonds. They’re not dollars.
Lost in this thread, was my response to Johnny Evers incorrect or were you referring to his post?
Joe, you got it right. The dollar is taken from the bond buyer and transferred to someone else. The bond is issued to the bond buyer as NFA. Sorry for the confusion. My response was to JE.
If a T-bond is a traditional bond, then it must be paid off. If is paid back, then obviously monetization has not occured.
But do you believe that we will pay down these bonds with tax dollars?
I thought the understanding is that Treasure debt will never be paid back in the traditional sense.
…
I do believe that T-bonds are the same as dollars. Most of us cannot avoid holding our cash in some form of Treasuries, money markets, for example. That’s why we had such a panic in 08 when money markets fell below par.
Money market funds primarily hold corporate credit and commercial paper. THAT is why they broke the buck in 2008, not because of anything having to do with US Government debt.
Also, Treasuries serve a different purpose than corporate debt. The Government should not be around to serve its own purposes the way a corporation is. Cash flow in the form of tax revenue are not the end goal like cash flow in the form of regular revenue is for a corporation. Corporate debt is used to bolster working capital, Treasury debt is used to bolster the NFA of the private sector.
Why does it “have to be paid back”? In the aggregate, debt is never “paid back”. Not private debt, not public debt. If the economy grows then the money supply expands in an elastic form to meet the growing needs of the economy. Now, if all the little old grand ladies in the country decide they don’t want interest earning savings then I guess the Fed could QE up all the t-bonds and the Congress could tell the Tsy to stop issuing bonds and we could “retire the debt” and leave the grandma’s of the world saving nothing but a 0% piece of interest earning paper. But of course that’s not going to happen. The debt never “gets paid back”. This is a micro extrapolation out to a macro concept that doesn’t apply.
Although a private investor’s net worth hasn’t changed, his liquidity has improved, albeit only ever-so-slightly given the size of the secondary market in Treasuries.
While I agree the majority of private investors who suddenly find their bonds swapped out with cash will most likely plough it into another investment (e.g. equities), I’m sure there are a more than a few who would just say “To heck with it” and go out and buy stuff.
Whether the number of investors who do this is significant enough to create some semblance of demand-pull inflation is up for argument. I don’t know enough about human behavior in aggregate to say whether it would/wouldn’t.
Naturally, this is a moot point if (as you say) the Fed ALWAYS buys from banks. Banks obviously aren’t going to go out and buy jetskis with their excess reserves.
The Fed buys from banks. And the balance sheet of the bank is unchanged except in composition. Banks don’t spend more when they have more reserves just like you wouldn’t spend more if you sold Apple stock (assuming no capital gain). Economic agents spend as a % of current income. If current income is unchanged then spending should remain the same. QE does not increase current income or improve balance sheets.
One positive effect that is real for SOME companies is that with the Fed pulling down rates in general, companies with a lot of debt can roll it over at lower rates. Those savings push up profitability.
Well, there is a change. When FED buys a t-bill or toxic mortgage assets from banks it is converting non-liquid assets into liquid asset(cash). Due to QE operation the capital ratios of the banks improve allowing them to take more risk. In addition it increases confidence resulting in more transactions between the banks. This increases liquidity and speculation in the market. In the process inflating equity and futures markets.
Basically, QE is code name for “helping my bankers buddies”. QE is to help top management to get away with fat bonuses they earned by pushing bad loans and generating temporary revenues due to transaction fees on all bogus financial derivative instruments.
Cullen, is this his article http://www.zerohedge.com/news/short-term-ecb-dollar-fx-swaps-fed-soar-highest-december-2009 as significant as ZH makes it out to be?
Whoops meant to post this in the ask Cullen part.
Hi Undergrad,
I wouldn’t say it’s a panic sign, but it’s certainly a sign of continuing stress in Europe. I think ZH is right that it’s foolish to assume this crisis has been contained or resolved. It clearly hasn’t.
Cullen wrote: “Why does it “have to be paid back”? In the aggregate, debt is never “paid back”.
If it never has to be paid back, then it was monetized in the first place. In that case, there is $15 trillion out there that was printed by the federal government and put into the economy to help keep it humming along. Not saying there is anything wrong with that, necessarily. Just want you to admit that real money is being created by deficits.
The potential problem is that in 10 years there will be $25 trillion of debt out there — and the economy might not be growing, the interest on the debt will be staggering, rates will have to be kept low to keep borrowing costs low (and permanant low rates will lead to inflation), and all those grandmas might decide that since the dollar supply was growing faster than the economy maybe she shouldn’t be holding dollar-denominated bonds.
Yes, a new t-bond is created. We’ve gone over that. But unless you call a t-bond “money” then no new money is being created through deficit spending. Personally, I would say the moneyness of t-bonds is below that of a cash note. Either way, NFA is created….But you’ve completely changed the topic from QE to deficit spending. QE has NOTHING to do with deficit spending. The deficit spending happens whether QE is implemented or not.