Introduction
Quantitative easing (QE) is a monetary policy to increase the money supply by injecting liquidity into the economy, when standard policies have become ineffective. A central bank buys financial assets from commercial banks, thus increasing the monetary base or the capital within the financial sector, thus increasing the amount which banks lend to consumers and small businesses, in an effort to promote economic growth. It is usually done when interest rates are already extremely low and there are no other measures which can be taken.
When Lehman Brothers collapsed in September 2008, confidence in the world economy plummeted to the point where financial markets became dysfunctional and credit conditions were severely constrained. With the short-term rates approaching zero in 2008/early 2009, the Federal Reserve, the Bank of Japan (BOJ), the Bank of England (BOE), and the European Central Bank (ECB) began to pursue more unconventional monetary policies - including forms of quantitative easing - to stimulate economic growth.
QE – Operational Mechanics
Before delving into the mechanics of a QE transaction, it’s important to understand what exactly “cash” is. Cullen Roche from Orcam Financial Group explained (https://www.pragcap.com/understanding-quantitative-easing/), “Cash” is simply the most liquid liabilities of a government that is in control of fiat money. Cash can be considered to be a treasury bill with very short maturity. The major difference between “cash” and the bills is the duration and the amount of interest they both pay. When someone owns a t-note, one has just traded one’s “cash” for a slightly less liquid form of the same exact thing. If the Fed buys those t-notes from the individual, they give him back his cash minus the interest. That’s all that is involved. There is no change in anything except the interest the owner of the t-note was earning. If the government removes t-notes, then all they are doing is altering the term structure of their liabilities. They are not changing the amount of liabilities.
Many investors were betting on the inflationary impact of QE. But again, as Mr. Bernanke explained, there is no reason to believe that QE is inflationary. Why? Because the Fed is not adding net new financial assets to the private sector. The assets already existed. They are merely swapping reserves for bonds. They are giving the banks a checking account instead of a savings account, so to speak. If Bank A owned a 1.2% 5-year note and they sell that note to the Fed, they receive reserves earnings 0.25%. Their savings account was changed to a checking account. Nothing else except the duration and the rate of the paper has changed. The number of assets in the system is the exact same.
Simplified view of assets of a bank before and after QE is enacted
The point here is that from an operational point of view the Fed is altering the money supply without creating bonds. There might be some slight change in the bonds the Fed purchases, but this is offset by the fact that the private sector is losing interest income they would have otherwise earned. For instance, in QE1 the Fed removed $1.2T in assets from the private sector. Much of this was high yield paper. We know that the Fed turned over approximately $50B to the U.S. treasury (its “profits”) from QE1. What did the banks get in return? They got a checking account at the Fed earning 0.25% or roughly $2.5B over the course of QE1. So, the private sector lost about $47.5B in interest income it would have otherwise earned.
So, one might be wondering why the banks are even doing this to begin with. Well, QE supposedly changes the term structure of the bond market. Fewer 5-year notes should lower interest rates and entice borrowing, generate lending, make other assets more attractive, etc. If the private sector sells bonds to the Fed and receives low interest-bearing cash, it might want to rebalance its portfolio. Mr. Bernanke was hoping that it would reach out on the risk curve and buy equities or corporate debt. But the price one purchases those securities at will depend entirely on their fundamentals and the price that the buyer and the seller agree upon. If one runs out and bids up risky assets just because one thinks the Fed is “printing money” then one is making a grave mistake. We believe, many investors did make that grave mistake.
QE – Transmission Channels
As explained by Joyce, Tong and Woods of BOE, the following channels should be considered at least for a qualitative analysis of QE. Krishnamurty and Vissing-Jorgensen looked at different channels for a quantitative analysis. (Arvind Krishnamurthy and Annette Vissing-Jorgensen(2011): Effects of quantitative easing on interest rate)
We will consider the qualitative analysis, when we discuss the impact of QE on the economy.
Spending and inflation channel: The aim of undertaking asset purchase is the same as a cut in interest rate, and to stimulate nominal spending and thereby domestically generated inflation. Purchases of financial assets should initially increase broad money holdings, push up asset prices and stimulate expenditure by lowering borrowing costs.
Policy signalling channel: This channel signifies information that economic agents gather as regards the likely path of the future monetary policy from asset purchases. Generally speaking, policy announcements on asset purchases might contain news about the underlying state of the economy.
Liquidity channel: When financial markets are dysfunctional, central bank asset purchases can improve market functioning by increasing liquidity.
Bank lending channel: When assets are purchased from non-banks, the banking sector gains both new reserves at the central bank and a corresponding increase in customer deposits. The higher level of liquidity may encourage banks to extend new loans.
QE – Economic Impact
The QE policy aims to increase money supply through asset purchasing. An increase in money supply shifts the LM curve (Liquidity Preference and Money Supply Curve) to the right. Anything that shifts IS (Investment and Saving) or LM apart from a change in prices will shift the aggregate demand curve. There are several ways in which change in LM is transmitted to a change in AD. An increase in money supply reduces the short-term rates changing future expectations about their direction. This might also have an effect on long-term interest rates that determine level of borrowing in the economy. This implies that less volatile future expectations about the long-term interest rates will boost the investment and asset prices, as businesses will have easier access to working capital due to lower yields. (‘portfolio balance effects’- Joyce, Tong and Woods)
Qualitative economic impact of QE (source: Joyce, Tong and Woods of BOE)
The overall macroeconomic effect of asset purchases can be broken down into two stages: an initial impact phase and an adjustment phase , during which the stimulus from asset purchases works through the economy. In the impact phase asset purchases change the composition of the portfolios held by the private sector, increasing holdings of broad money and decreasing those of medium and long-term gilts (as it is in the case of the UK market). But because gilts and money are not perfect substitutes, this creates an initial imbalance. As asset portfolios are rebalanced, asset prices are bid up until equilibrium in money and asset markets is reached. This is reinforced by the signalling channel and the other effects of asset purchases mentioned above, which may also act to raise asset prices. Through lower borrowing costs and higher wealth effect, asset prices then raise demand, which acts to push up the consumer price level.
In the adjustment phase , rising consumer and asset prices raise the demand for money balances and the supply of long-term assets. The initial imbalance in money and asset markets shrinks, and real asset prices begin to fall back. The boost to demand therefore diminishes and the price level continues to increase but by smaller amounts. The whole process continues until the price level has risen sufficiently to restore real money balances, real asset prices and real output to their equilibrium levels. Thus, from a position of deficient demand, asset purchases should accelerate the return of the economy to equilibrium.
QE – Current Status
The Fed currently owns a bit more than $3.8 trillion in assets, against roughly $1.7 trillion in currency, $1.6 trillion in bank reserves, and $500 billion in other liabilities, including some $250 billion owed to foreign central banks. (Source: Barron’s)
According to the FOMC meeting minutes of January, “almost all participants thought that it would be desirable to announce before too long a plan to stop reducing the Federal Reserve’s asset holdings.”. Jerome Powell, the current Fed chairman, stated: “If banks want to use reserves for a good and sufficient reason…we’re not going to discourage them from holding them.”
Some market participants now expect the Fed to administer a round of mini-QEs before the year-end. The financial market will be listening very carefully to what the Fed has to say on Wednesday next week.
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