QE For Dummies

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.

Comments

[Whitebear]

Well. This author doesn't think so. He listed out why QE2 is different from QE1. You're correct that with QE1, the money was being kept at the extra reserve. That's a different story when it comes to QE2.

You want to refute this?

http://news.goldseek.com/GoldSeek/1288978710.php

[yelnick]

whitebear, I wrote about QE1 at the time - essentially what the Fed did was to centralize the interbank market, which had been freezing up due to fears of Citi bankruptcy. It was a good move and is what central banks should step in and do. The extra $1T of reserves essentially put into the Fed obligations between banks for checking accounts that existed anyway - no new money.

QE1 had a risk of an exit strategy - once the banks got back on their feet, wouldn't they suck down the reserves by excessive lending? Well, that hasn't happened. It would take an improvement in the lending climate for that to occur, and the banks would lend regardless of these reserves.

I agree with the author that QE2 is different, especially in that the new reserves are not being sterilized by asset swaps in the real economy.

I disagree with his assertion that this time "real" money is being created to be spent by the Federal government. The Federal government would issue its bonds and spend the money regardless of QE2. QE2 does not change that. The rest of his argument follows from that premise, which is flawed. Real money is not rushing into the money supply but being logjammed into reserve accounts in the Fed.

I also disagree with his analysis that the banking system is being hollowed out by QE2. After first asserting that the Fed is adding money to the real economy, he then says the Fed is "taking" bank assets away from the banks, removing it from the real economy. He cannot have it both ways. If the Fed is removing assets from banks, then it is not creating new money that escapes into the economy.

The issue for the Fed remains its exit strategy when the real economy recovers and banks begin lending at scale again. This is where inflationary expectations are coming from.

The other issue is that the banks - which are the primary bind dealers - make a sweet return selling bonds to the Fed in QE2. This enables them to continue speculation, especially in commodities and stocks. Bernanke explicitly is wishing for a new stock bubble.

I think the bigger issue is how our trading partners react. At some point they will force the US to get its act together, and may impose a new reserve currency regime on the US. Game over.

[Hockthefarm]

Yelnick:

Isn't QE2 a direct manipulation of our currency to drive the dollar down and make our goods cheaper around the world.

I just came back from a business trip to Turkey. Istanbul, great city, well educated, hard working, great people. I'd relocate there in a heart beat.
Spent the last few days on the coast in Antalya and Ismir.

But wow, is it ever expensive. A good cup of coffee was 8 to 10 bucks and it looked like a wopper, fries and a coke was about 24$ at the airport. Bacon, eggs, toast and coffee in Frankfurt was 30$.

Friends heading to Australia later this week tell me that 100 Aussie costs about 102$.

All this bull crap about our economy and our markets is just that is seems. A bit of travel puts it into perspective. The gubmint has effectively denied US citizens to right to travel abroad. Soon they will have us living like rats with massive levels of public debt. And I'm not sure anyone here really cares. For someone in their 50's, I'm not sure a 401k is worth having. Bernanke is going to make them essentially worthless long before we spend them.

Hock

[Ratbastrd]

Yelnick,

Most of what you say makes sense. However (right or wrong) the net effect of QEII debases of the dollar. A lower dollar might help exports but is destroys the supply side for business. As you note the dollar debasement increases the cost of goods and margins are compressed. Thus there is a real inflationary effect.

Please help me understand why QEII should not effect the value of the dollar?

[yelnick]

Ratbastrd, the announcement of QE2 has already hammered the Dollar and riled up our trading partners, many of which are intervening to prevent their currencies from running up and hurting exports. In doing this, they increase internal inflation. Caught between a rock and a hard place. This interventions have caused the USD to reverse, at least for the moment.

The US can play this game longer than anyone else since we are the reserve currency. It works for a while even if the extra reserves never escape into the real world because it creates an expectation of inflation. Quite obvious in the parabolic flight of commodities for the past few months.

The interesting question is what happens when markets realize the QE effort is not that inflationary? The USD should run UP and the commodity bubble should BURST. Will be quite violent when it occurs. The reversals this week have been early warning signs. Wait to see how markets settled down - or not - after G20.

[yelnick]

Hock, a lot of people believe the QE policy is a deliberate currency debasement. Among those are: the Chinese, the Germans, the Brazilians. They are ready to take on the paper eagle this weekend at G20. So far Geithner and Obama seem inclined to accommodate (ie the blink first). No one in DC seems to have the stomach for the fight as we saw with Nixon in 1971 or Reagan in 1985.

[Ratbastrd]

So what I am hearing is that this bubble might burst sooner then anyone expects. How would you then characterize the effects of the POMO schedule on equities? Is this also a paper tiger?

[yelnick]

ratbastrd - markets react faster than fundamentals, which is why the old saw is 'buy on rumor, sell on news'. markets already have discounted a fair amount of QE, and so now the question is whether the future path is above/below already priced-in expectations.

markets also react irrationally, which is where we see parabolic rises or excessive falls. right now we have clear parabolic rises in metals and many commodities

hence it may be the parabolic (irrartional) phase is over and about to correct .. and equities will react to changes in expectations of POMO activities.

my take is that we get a stock correction then a final move into May/Jun, at which time QE will be old news and new economic conditions will be apparent: double-dip/muddle-thru/recovery! or whatever