“The psychological impact of QE due to its many myths is extremely powerful.” – Cullen Roche
Tonight will be the first of two showings of Money for Nothing: Inside the Federal Reserve at Kimball’s Theater here in Colorado Springs. There are still a few seats available for tomorrow night, so please consider joining us! So far in our Fed Ed series we’ve looked at the history of the US banking system, reviewed the first 100 years of the Fed’s activities and provided an outline of the Fed’s structure and basic operations in the financial markets. This week we conclude with a focus on the highly controversial policy of quantitative easing.
Quantitative easing has been one of the Fed’s primary policy tools since the financial crisis five years ago. It is also one of the most widely misunderstood, hotly contested and broadly influential policies implemented anywhere on the globe in recent history. In this post we will try to provide a balanced analysis by boiling this policy down in a simple, understandable way.
Quantitative Easing Defined
Quantitative easing, or “QE”, refers to the central bank’s practice of buying securities in the open market with money that was created ex nihilo – out of nothing. Quite literally, the Fed purchases the security from a private market participant by crediting their account electronically with US Dollars that didn’t previously exist.
In one sense this practice is not that unusual. As we saw last week in Pulling Back The Curtain, one of the primary ways in which the Federal Reserve implements its monetary policy is through open market operations – the buying and selling of government-backed securities on the secondary market. These operations are typically confined to the ultra-short term interbank lending markets where they add and drain reserves out of the banking system in order to manipulate the fed funds rate to a target level. So it is through open market operations that the Fed even has the ability to set short-term interest rates.
According to Wikipedia, however, “Quantitative easing (QE) is an unconventional monetary policy used by central banks to stimulate the national economy when conventional monetary policy has become ineffective.” So what makes QE so unconventional? It’s the fact that the securities being purchased are longer maturity and might even include bonds other than US Treasuries.
The Virtuous Circle
The stated goal of QE is to put downward pressure on long-term interest rates. Lower interest rates encourage borrowing which in turn lead to investment. The influx of money into investable assets lifts the price of those assets which creates a “virtuous circle” by spurring more borrowing and spending in the economy. Bernanke referred to this cycle in a 2010 article he penned for the Washington Times:
“…higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”
This objective was reiterated just last week (three years after Bernanke’s Op-Ed) by Janet Yellen in her Senate confirmation hearing:
“The purpose of our policies, all of them, is to bring down interest rates in order to spur spending in interest sensitive sectors, and if we’re capable of doing that, that will help to stimulate a favorable dynamic in which jobs are created, incomes rise, more spending takes place and that creates more jobs throughout the economy.”
So while the stated objective of QE is to impact interest rates, the ultimate motivation is much more psychological. Simply put, the Federal Reserve is in the mood management business. Inflated asset prices should lead to more optimism and looser wallets amongst American consumers. The theory (and hope) is that this will become a self-fulfilling prophecy of economic growth that will gain momentum and eventually stand up on its own two feet without any further stimulus from the Fed.
QE = Money Printing?
There is a widely held view that quantitative easing is essentially money printing, and that “Helicopter Ben” might as well be dropping dollar bills from the sky. While there are certain elements of this argument that are true, it’s important to know what is meant by the term “money printing.” We believe most people’s definition is somewhat misinformed, and as Dylan Grice recently penned in the Edelweiss Journal, “sloppy language leads to sloppy thought.” Let’s bring some clarity to this issue by considering what actually happens when the Fed purchases an asset in the open market as part of its QE program.
Scenario: The Federal Reserve buys a $1,000 bond from a bank
Private Sector Balance Sheet
Assets: Unchanged. (The bank has swapped a $1,000 bond for $1,000 in reserves.)
Liabilities: Unchanged. (The transaction doesn’t impact any liabilities of the bank.)
Net Worth: Unchanged.
Federal Reserve Balance Sheet
Assets: Increased by $1,000. (The Fed now owns a $1,000 bond that it didn’t own before.)
Liabilities: Increased by $1,000. (The Fed has $1,000 of new bank reserves on deposit.)
Net Worth: Unchanged. (Assets and liabilities both increased by an equal amount.)
The net impact of a QE transaction is not to increase the financial account of the private sector. Rather, what occurs is essentially an asset swap in which the bank trades a $1,000 asset for $1,000 in cash. The composition of the private sector’s assets has changed, but the total amount of private sector net worth has remained the same. Meanwhile, the Fed’s balance sheet is expanding in size as both the assets and liabilities side increases in tandem with every QE transaction. The chart below reveals how significant this expansion has been since the Fed embarked on this QE journey.
It’s widely believed that every dollar of QE adds a dollar to the money supply, but this is not the case. In order to understand why, it’s important to know the distinction between the monetary base and the money supply. The monetary base case be thought of as the raw material that the banking system starts with, and the money supply is what that base money is multiplied into via the lending and deposit cycle. Assuming a 10% required reserve ratio, the banking system can take $1 of base money and turn it into $10 of money supply. (See fractional reserve banking for a more detailed explanation.)
Every dollar of QE removes a dollar of bonds from the system and adds a dollar of base money, thereby expanding the potential money supply. But until that base money begins getting lent out it sits idle in the form of excess reserves and the impact on the money supply is limited. This is, in fact, what we’ve seen thus far, and it’s the reason inflation has not yet become a real problem.
Alan Greenspan explained this in a recent interview on Bloomberg Surveillance:
McKee: Does a very large central bank balance sheet always and everywhere mean inflation ahead?
Greenspan: If it sustains itself as an economy picks up, and as the huge amount of excess reserves held by the depository institutions with the Federal Reserve finally begin to enter into the business economy then you begin to have problems. At the moment, the reason we have no inflation in the context of very large central bank balance sheets, is for the vast majority the increase are merely a bookkeeping transaction from the central bank to the depository institution. Until the commercial bank starts to relend those reserves and they begin to multiply in the banking system…until they do that, you have no effect on money supply...”
At some point in the future, the private sector will begin demanding more credit and the banks will begin supplying it. This will cause the enormous amount of base money in the system to begin multiplying into an increased money supply, sparking inflationary concerns and creating a problem for the Fed. One of the biggest questions surrounding the QE topic, then, is how the Fed will be able to manage this dynamic and drain liquidity out of the system at the appropriate time. There are a number of tools at their disposal to do this, and they have (of course) expressed a large amount on confidence in their ability to manage the exit. Still, it remains to be seen and there are plenty of reasons to be concerned that they’ve bitten off more than they can chew.
Quantitative easing is one of the most controversial and widely misunderstood policies in the modern era. Its direct impact on the real economy is debatable, but few would argue it has had significant influence on the psychology of financial market participants. Will it be hailed as the effort that shifted the tide and propelled the US economy out of its worst recession in a century, or will it be seen as an impotent policy that resulted in artificially inflated asset prices and unwanted inflation? We probably won’t know the answers to these questions for many years to come, but hopefully we’ve provided a little more clarity around some of the misconceptions held towards this controversial topic.
Author David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.
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