4 Questions Answered – Parts 1 & 2

I am pulling a good set of questions out of the discussion forum here because I think they’re important. Will, an astute Georgetown grad, asks:

1. We have previously said that QE is an asset swap. Previously a financial institution had an MBS or treasury security and now they have more reserves at the fed. Central bank gets a treasury security or mbs and gives cash (in the form of more reserves to banks) while the financial institution gets reserves at the fed and no longer has the security. In this context (assuming I am right?) I am trying to understand Tepper’s recent logic (https://pragcap.com/david-tepper-and-the-coming-cash-on-the-sidelines). Is he referring to the sellers of these securities who are not financial institutions putting money they receive into the market (1) or is he saying that the financial institutions will put the excess reserves they receive into the market (2)or some combination (3) ?

2) Also, why is he comparing this to $100 billion – does that $100 billion represent MBS/treasury securities issued, so is that how he comes up with the $400 billion “deficit” ?”

It’s always helpful to review the “Understanding QE” on this page before moving forward. There’s bit of simple accounting on that page in addition to a rather simple explanation and many links. One thing that is shown there is the different ways QE can occur. The way I usually describe it (for simplicity) is with a bank as t-bond seller. In this case, the bank sells a t-bond to the Fed and the Fed gives them a reserve deposit. It’s a pure swap. The private sector doesn’t have more financial assets (they lost a t-bond and gained a reserve deposit) and the asset on the Fed’s balance sheet can be thought of as being outside the real economy and having very little impact overall (the Fed doesn’t go to Wal-Mart) outside of the interest its assets remit to Treasury. The alternative scenario is when a non-bank sells a t-bond. In this case, the seller gets a bank deposits (asset for the seller, liability for the bank), the bank buys the t-bond, the bank on-sells the t-bond to the Fed and the bank gets a reserve deposit. Again, there’s no change in private sector net financial assets. It’s a swap with more steps inbetween because the bank acts as an intermediary.

So, the point David Tepper makes is with regards to the portfolio rebalancing effect. If the Fed is removing interest bearing assets from the private sector then that is likely to increase demand for other assets as savers will try to reallocate to make up for lost income. So they might sell t-bonds and then decide they don’t want to lose purchasing power in cash so they’ll replace that income source with corporate bonds or stocks. This MIGHT drive asset prices higher or it might actually drive prices down. As I describe in the piece you linked to, prices are not solely determined by the supply of assets but also by the demand. And the point I often make regarding QE is that QE has no transmission mechanism that necessarily improves the underlying fundamentals of the assets. So, you could actually have an environment where corporations perform poorly and the portfolio rebalancing effect doesn’t result in higher prices because the demand for those assets declines due to real fundamental deterioration of underlying assets. Saying that QE must drive asset prices higher is like saying that stock buybacks must drive stock prices higher. If only it were that easy! So there’s an element of the “cash on the sidelines” myth in Tepper’s thinking that isn’t necessarily correct.

On part 2 – Tepper’s point is more nuanced. He says we’re monetizing the debt (which I say is wrong from a very technical perspective and already proven since demand for t-bonds INCREASED when QE ended even though many money managers said yields would skyrocket back then). Which is only true in the sense that we’re transforming some t-bonds into bank deposits or reserves which, as MRists know, are assets with a higher level of moneyness than something like a stock or bond (because those assets must be transferred to something like deposits to be useful in a real economic sense like going to Wal-Mart). This doesn’t automatically mean more inflation, but it could mean the portfolio rebalancing effect as described above.

Tepper is noting that the Fed has basically been offsetting NEW T-bond issuance during QE. That is, we’ve been running a deficit of about $1T per year or $85B per month AND the Fed has been scooping up those bonds. So it’s actually been a wash. QE is asset supply neutral in this regard. But it won’t be going forward. The private sector will actually start experiencing a significant t-bond shortage in the months ahead because the deficit is shrinking to something closer to $50B per month and the Fed is still buying $85B per month. So there’s a disconnect there resulting in what Tepper thinks will lead to an even more exaggerated portfolio rebalancing effect.

Whew. Lots of moving parts there. I hope it makes sense and thanks for the great question!

Helpful links:

• Understanding the Modern Monetary System
• Understanding Quantitative Easing