By Marshall Auerback, a portfolio strategist and Roosevelt Institute Fellow
As any student of Economics 101 realises, you can control the price of something, or the quantity, but not both simultaneously. In announcing its decision to purchase an additional $600bn of treasuries last week, the Federal Reserve presumably intended to create additional stimulus to an economy, since tepid growth has failed to make a dent in unemployment. Even Friday’s “good” unemployment numbers, where the US economy added 151,000 jobs, were not enough to reduce the current jobless rate of 9.6%.
So is a new round of “QE2” going to do the trick? It would be interesting to figure out how the Fed came to the magic number of $600 billion. Why not a trillion? Why not $250bn? Why $75bn a month? There’s an element of sticking one’s finger in the air and hoping for the best. The Bernanke Fed is slowly reaching Greenspan-like levels of incompetence.
Let’s go back to first principles: Quantitative easing involves the central bank buying financial assets from the private sector – government bonds and maybe high quality corporate debt. In this particular instance, the Fed has announced it will buy $75bn of treasuries a month. So what the central bank is doing is swapping financial assets with the banks – they sell their financial assets and receive back in return extra reserve balances. So the central bank is buying one type of financial asset (private holdings of bonds, company paper) and exchanging it for another (reserve balances at the central bank). The net financial assets in the private sector are in fact unchanged although the portfolio composition of those assets is altered (maturity substitution) which changes yields and returns.
Central bank demand for “long maturity” assets held in the private sector reduces interest rates at the longer end of the yield curve. These are traditionally thought of as the investment rates. This might increase aggregate demand given the cost of investment funds are likely to drop. But on the other hand, the low rates reduce the interest-income of savers who will reduce consumption (demand) accordingly.
Essentially, then, you have a supply side response to a problem of aggregate demand. The cost of investment funds might well drop, although that’s not 100 percent clear. Consider the following example: Let’s say the Fed simply targeted the 10 year treasury at 2.25%. The central bank would have a bid at that level and buy all the securities the market didn’t want to buy at that level. They may in fact buy a lot or a very few, and possibly none at all, depending on Treasury issuance, investor demand, and market expectations.
But the FOMC has announced a limit to the Fed purchase program, both in terms of the monthly amounts and the total quantity. How high will 10 year notes trade with the billions free to trade at market levels?
It could be at much higher yields, which presumably defeats the whole purpose of the program. Of course, if the Fed bought every single 10 year treasury, then for sure they could maintain that rate indefinitely; but then they would have to preclude announcing a specific amount that they wished to purchase. Of course, if the Fed did this, people would undoubtedly squawk about “printing money” and “creating inflation” but again, QE does not actually create new net financial assets.
In fact, the Fed has done nothing but TALK about its plans over the past several months, but has yet to initiate the program. There has been no widespread “money printing” or “currency debasement”. The Federal Reserve announced an INTENTION to do something and private portfolio investors took their cue from that. But as any Asian central banker can tell you, private portfolio preference shifts are notoriously fickle, with conflicting motives. The term structure of rates in Japan would imply a comparable intent to make holding yen unattractive, yet 10 year government bonds in Japan yield less than one percent and the yen remains resolutely strong against the dollar.
Is there another method by which the Fed could influence the long term structure of interest rates? Why not just stop issuing 10 year government paper? If the Treasury had announced they were eliminating everything longer than 2 year notes for new issues there would hardly be any screams of “money printing”?
And how low would the 10 year go?
If the objective is to allow the banks to earn their way out of insolvency, then QE2 is also an ineffective means of doing this, since it flattens the yield curve, but still engenders interest rate risk on the part of the banks which persist in “playing the yield curve”, especially via leverage. There is a more effective means of doing promoting bank profitability in a comparatively risk free way, as my colleague, Randy Wray, has noted:
[T]here is nothing wrong with offering longer-maturity CDs to replace overnight reserve deposits held by banks at the Fed. Banks are content to hold deposits at the Fed—safe assets that earn a little interest. They are hoping to play the yield curve to get some positive earnings in order to rebuild capital. If they can issue liabilities at an even lower interest rate so that earnings on deposits at the Fed cover interest and other costs of financing their positions in assets, this strategy might work. That is what they did in the early 1990s, allowing banks that were insolvent to work their way back to profitability. The Fed could even lend to banks at 25 basis points (0.25% interest) so that they could buy the CDs, then pay them, say, 100 or 200 basis points (1% or 2% interest) on their longer maturity CDs. The net interest earned could tide them over until it becomes appropriate for them to resume lending to households and firms.
To be clear, we are not necessarily advocating banks play the yield curve to restore profitability (far better to have a payroll tax cut for that), or that they get such an arbitrage from the Fed, only that it would work with less risk both to the bank and the financial system than what will result from QE. Ultimately, if the objective is to allow banks to restore profitability via traditional lending activities, then there are far more obvious ways to do so. Let’s first recall that BANKS DO NOT LEND THEIR RESERVES, as is always depicted in the economics textbooks via so-called “fractional reserve lending”. The Federal Reserve Bank is a bank, just like Citibank or Wells Fargo. The Treasury has an account at the bank, just as you or I have a checking account at our local bank. Other banks, like BofA and Wells Fargo have accounts at the Fed as well, and they are called reserve accounts (for more see here).
Reserve accounts are not made up of money held in reserve in case a loan goes bad, they are money held at the Federal Reserve for payment settlement. The reserves of money held in case loans go bad are capital. They are not lent out. The way banks actually operate is to seek to attract credit-worthy customers to which they can loan funds to and thereby make profit. What constitutes credit-worthiness varies over the business cycle and so lending standards become more lax at boom times as banks chase market share. But that’s a function of credit analysis (or the lack of it, as the cycle matures), NOT the bank’s reserve positions.
These loans are made independent of their reserve positions. At the individual bank level, certainly the “price of reserves” will play some role in the credit department’s decision to loan funds. But the reserve position per se will not matter. So as long as the margin between the return on the loan and the bank’s marginal cost of funds is sufficient, the bank will lend
So as long as the margin between the return on the loan and the rate they would have to borrow from the central bank through the discount window is sufficient, the bank will lend (for more explanation, see here).
Consequently, the idea that reserve balances are required initially to “finance” bank balance sheet expansion via rising excess reserves is inapplicable. A bank’s ability to expand its balance sheet is ultimately dictated by the presence of creditworthy borrowers, which is a function of FISCAL POLICY. Instead of expending political capital on pointless accounting shuffles and financial guarantees, or programs such as TALF, TARP, Term Auction Credit, or the Commercial Paper Lending Facility, one could simply implement a $2 trillion tax cut (or spend it via the government, or do revenue sharing with the states), thereby generating increased spending power in the economy, providing significantly higher multiplier effects and ultimately shifting the economy back to self-sustaining growth. This would be far more effective than continuing an endless array of silly Fed programs, which do nothing but diminish the central bank’s credibility and have had minimal impact in terms of economic growth.
In many respects, the markets are already implicitly conceding the ineffectiveness of “QE2”. Within hours of the program being announced, there were stories of “QE3”. Instead of having a situation where the markets “buy the rumor, sell on the news”, it appears to have been more a case of buy the rumor and then double up on the news.
We’ve truly hit amateur hour at the Fed. We’re inciting speculation and the Federal Reserve is acting like the kid in his car seat who keeps turning his toy steering wheel as much as it takes to turn the car. Toy cars, however, won’t get you very far if you plan a long journey, and likewise QE2 is a pretty ineffective vehicle if one wishes to engender genuine economic growth. Eventually, investors will realize they’ve been conned (yet again) by the Fed and the end result won’t be pretty.Scott Fullwiler
Many in the financial press have noted the rise since September 2008 in the Fed's reserve balances from about $20 billion to more than $800 billion today. A number of well-known economists have expressed concern that this will be inflationary.
However, fears that these are inflationary are misplaced, even inapplicable, as they apply only to a monetary system operating under a gold standard, currency board, or similar arrangement, not the flexible exchange rate system of the U. S.
Under a gold standard, for instance, banks must be careful when creating loans that they have sufficient gold or central bank reserves to meet depositor outflows or legal reserve requirements. This is the fractional banking, money multiplier system standard in the economics textbooks. If there is an inflow of gold, then bank deposit creation can increase and prices can rise. The same can occur if the central bank raises the quantity of reserves circulating relative to its own gold reserves.
But that's not the case under modern monetary systems with flexible exchange rates.
In the U. S., when a bank makes a loan, this loan creates a deposit for the borrower. If the bank then ends up with a reserve requirement that it cannot meet by borrowing from other banks, it receives an overdraft at the Fed automatically (at the Fed's stated penalty rate), which the bank then clears by borrowing from other banks or by posting collateral for an overnight loan from the Fed. Similarly, if the borrower withdraws the deposit to make a purchase and the bank does not have sufficient reserve balances to cover the withdrawal, the Fed provides an overdraft automatically, which again the bank then clears either by borrowing from other banks or by posting collateral for an overnight loan from the Fed.
The point of all this is that the bank clearly does not have to be holding prior reserve balances before it creates a loan. In fact, the bank's ability to create a new loan and along with it a new deposit has NOTHING to do with how many or how few reserve balances it is holding.
In other words, there is no loan officer at any bank that checks with the bank's liquidity officer to see if the bank has reserves before it makes a loan.
What constrains a bank in the creation of new loans and deposits, then? First, there is the fact that there must be a willing borrower . . . one whom the bank deems to be creditworthy. Second, the loan must be perceived as profitable . . . in this case, the bank's ability to raise deposits does matter, since it probably expects the borrower to withdraw the deposit it will create, and finding new deposits is much cheaper for the bank than borrowing from other banks or from the Fed. Third, the loan must be on the regulator's approved list of assets, and if the loan results in an expansion of the bank's balance sheet, the bank must be aware of the impact on its capital requirements and other financial ratios with which the regulator is concerned.
But, how many reserve balances the bank is holding does NOT affect its operational ability to make the loan.
Most fears expressed by economists, policymakers, and the financial press regarding the rise in reserve balances since September presume—like the inapplicable money multiplier model—this will necessarily lead to excessive creation of loans and deposits by banks and thus rising inflation.
But this cannot possibly be true. Banks have the same ability to create loans with $800 billion in reserve balances that they had with $20 billion. The difference now is mostly that they do not see as many creditworthy borrowers coming through their doors, given the deep recession, which has led them to create fewer loans.
Admonishments of banks by members of Congress for "not lending out the TARP funds" make the same mistake. Banks don't lend out TARP funds or any other funds. They create loans and deposits out of thin air, then use reserve balances to settle payments or meet reserve requirements.
For further evidence, consider two recent extreme cases:
In Canada, reserve balances have been effectively zero for over a decade now, and bank lending continues as it does anywhere else. Canada's inflation also has been similar to that of the U. S.
In Japan, under the so-called quantitative easing regime of 2001-2005, reserve balances reached around 15% of GDP, and the monetary base (reserve balances plus currency in circulation . . . often termed "high powered money") reached 23% of GDP. But Japan has, if anything, experienced deflation during and since this period, which is not surprising, since—again—the rising quantity of reserve balances did not enhance Japanese banks' abilities to create loans.
In the U. S., by comparison, reserve balances have reached about 6% of GDP, with the monetary base rising from about 6% to about 12% of GDP since September 2008. Those fearing rising Fed reserve balances apparently haven't noticed that an increase in reserve balances about three times the size in terms of GDP already happened in Japan, with none of the effects that have been predicted for the U. S.