There is lots of confusion over quantative easing (QE), so much so the markets may have over-reacted. I have been following PragCap's analysis, which is very good, but dense and lengthy to read, so let me try to simplify:
The Treasury sells bonds to Primary Dealers (banks), who resell to the public.
- In QE, the Fed steps in and buys many of those bonds.
Where does it get the money from?
- It creates it out of thin air
Isn't this inflationary?
- No, since the new money goes into the reserve accounts of the banks.
What are these "reserve accounts"?
- Deposits the banks keep at the Federal Reserve (see where the name came from?)
Why isn't this inflationary?
- Because the money sits in the Fed rather than circulating in the wild
What a minute. Didn't the Treasury get new money, and won't they spend it?
- Of course, that is why they sold the bonds to the primary dealers
So why isn't that inflationary?
- This happens all the time when Treasuries get floated, but the buyers have to pull money out of someplace else to buy the bonds
Yes, but this time the Fed is creating money out of thin air, instead of the prmary dealers (banks) pulling it out of the economy
- Right, but again it ends up in reserves not in the economy
Here is a chart which shows the before and after picture. You can see the new bonds bought by the banks (primary dealers) are swapped for reserves.
Why don't the banks use those reserves to lend, putting the new money into the economy?
- THAT would be inflationary, but they are not doing that
This is the crux of the confusion. Cause and effect are the other way around:
- Banks don't lend because they have more reserves; they lend when they can make money on the deal
For a long time banks have not been reserve-constrained. They can easily borrow from the Fed when they need liquidity. This is why the current crisis is NOT a liquidity crisis like the 1930s. History shows that bank reserves go up AFTER they increase lending, not before.
Why won't QE make the climate for investment by banks better?
- Unlikely. QE is trying to reduce longer term rates, but banks make money by borrowing short term and lending long term at higher rates. When the spread is decreased, lending stops.
What is the Fed up to?
- Bernanke has stated that he hopes stocks go up, creating a wealth effect, and the extra wealth gets spent, propping up consumption
Does this make sense?
- No, since it does not create extra money - the stocks you sell are bought by someone else, so the net money is the same. At best you get a little boost due to margin accounts - the buyer could use debt to buy more and not use as much cash. The real hope is stock sellers spend more and invest less; but then stocks will stop going up
Here is CNBC on the QE2 wealth effect:
Then what is he really up to?
- Lots of speculation on this. Maybe he is worried that the amount of government debt that we need to finance - both new debt and old debt rolling over - is about to overwhelm capital markets. We would either need to raise taxes or interest rates - both of which would short circuit the recoveryless recovery.
What about all the signs of inflation?
- The market in its confusion expects inflation. Commodities are way up, and the inflation-adjusted bonds (TIPS) are showing higher signs of inflation
This chart from Calafia Beach Pundit shows how the long bonds are not behaving as Bernanke wants. Their yields are going up, not down, signaling inflationary expectations:
We could end up in a bad place: commodities go up, squeezing middle class families and compressing business margins, as their inputs get more expensive but they lack the ability to raise prices.
Well, aren't stocks a good place to be?
- Japan's recent experience with QE says be careful. As PragCap concludes:
[I]n Japan ... QE caused a brief 17% rally in equities as speculators leveraged up, jammed prices and then later realized that the slightly lower yields hadn’t really changed anything. What happened next? Their equity market fell 40%+ over the next two years. QE was a great big “non-event”. All it did was manipulate markets temporarily and cause a huge amount of confusion.