How Quantitative Easing Really Works
If you want an accurate explanation of quantitative easing, here it is. I am going to describe the basic mechanics and the transmission mechanism to the rest of the economy. To the degree there is official documentation on the mechanics, I will refer to it here in order to use the Fed’s own voice in describing QE. Let’s start with the mechanics.
The Mechanics of QE
In March of 2010, the Fed described QE this way in a paper written by Joseph Gagnon, Matthew Raskin, Julie Remache, and Brian Sack on the New York Fed’s website:
Since December 2008, the Federal Reserve’s traditional policy instrument, the target federal funds rate, has been effectively at its lower bound of zero. In order to further ease the stance of monetary policy as the economic outlook deteriorated, the Federal Reserve purchased substantial quantities of assets with medium and long maturities. In this paper, we explain how these purchases were implemented and discuss the mechanisms through which they can affect the economy.
So quantitative easing is simply large scale asset purchases (LSAP) by the central bank. The central bank is permitted by law to purchase a wide range of assets including but not limited to Treasury securities, mortgage-backed securities, or municipal bonds (see Blanchflower: The Fed Should Buy Munis And Monetize State Debt). Before the first round of quantitative easing, the Federal Reserve’s asset base consisted mostly of Treasury securities. However, as bond market liquidity dried up, the Fed stepped in and purchased a panoply of assets in the first round of quantitative easing including many mortgage-backed securities.
The Fed is currently in the process of purchasing nearly $1.75 trillion of Treasury, agency, and agency mortgage-backed securities through the LSAP programs. We have already completed our purchases of Treasury securities, totaling $300 billion. And our purchases of agency securities and mortgage-backed securities (MBS) are well advanced. Indeed, we have completed purchases of $155 billion of agency debt securities to date, out of a target level of $175 billion, and of just over $1 trillion of MBS, out of a target level of $1.25 trillion.
The second round of quantitative easing was concentrated on purchases of Treasury securities. While the Fed had about $800 billion in assets in mid-2007, the first round of QE swelled this to $2.25 trillion by December 2009. The Fed’s asset base is now moving toward $3 trillion.
In the March 2010 paper, the NY Fed goes on to say:
We present evidence that the purchases led to economically meaningful and long-lasting reductions in longer-term interest rates on a range of securities, including securities that were not included in the purchase programs. These reductions in interest rates primarily reflect lower risk premiums, including term premiums, rather than lower expectations of future short-term interest rates.
But this is a subjective conclusion. The purpose of the paper is to provide the intellectual underpinnings to defend the Fed’s large scale asset purchases. Therefore, one should view the mechanics presented as objective and the conclusions as subjective. For example, In Sack’s December 2009 speech, he said:
The LSAPs were not aimed at supplying liquidity to financial institutions or at reducing systemic risk. Instead, they were intended to support economic activity by keeping longer-term private interest rates lower than they would otherwise be.
A primary channel through which this effect takes place is by narrowing the risk premiums on the assets being purchased. By purchasing a particular asset, the Fed reduces the amount of the security that the private sector holds, displacing some investors and reducing the holdings of others. In order for investors to be willing to make those adjustments, the expected return on the security has to fall. Put differently, the purchases bid up the price of the asset and hence lower its yield. These effects would be expected to spill over into other assets that are similar in nature, to the extent that investors are willing to substitute between the assets. These patterns describe what researchers often refer to as the portfolio balance channel. [EMPHASIS ADDED]
Sack is telling us that the Fed did not intend to perform a lender of last resort role, a legitimate Fed function. Rather, the Fed’s intention was to artificially supress risk premia to support economic activity. This is important to remember.
The money used to purchase these assets is created specifically for the transactions. That is to say the money did not previously exist before the transactions. This fact is what is behind the view that the Fed is ‘printing money’, a term Ben Bernanke, the Fed Chair also used when describing QE in 2009 (see Jon Stewart: The Big Bank Theory).
The Fed uses permanent open market operations (POMO) to conduct its large scale asset purchases. The Fed explains POMO this way:
The purchase or sale of Treasury securities on an outright basis adds or drains reserves available in the banking system. Such transactions are arranged on a routine basis to offset other changes in the Federal Reserve’s balance sheet in conjunction with efforts to maintain conditions in the market for reserves consistent with the federal funds target rate set by the Federal Open Market Committee (FOMC).
On March 18, 2009, the FOMC announced a longer-dated Treasury purchase program with a different operating goal, to help improve conditions in private credit markets.
On August 10, 2010, the FOMC directed the Open Market Trading Desk at the Federal Reserve Bank of New York to keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.
On November 3, 2010, the FOMC decided to expand the Federal Reserve’s holdings of securities in the SOMA to promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.
Note, August 2010 was when the Fed started QE2. November 2010 was when QE2 was first announced as the Fed decided to expand its balance sheet.
That’s the mechanics.
How QE actually works is the more subjective part of quantitative easing. Brian Sack told us in 2009 that the Fed was not performing its role as lender of last resort but rather it was ‘manipulating’ risk premia in order to lower long term interest rates to boost the real economy. I use the term ‘manipulate’ rather deliberately as I believe QE introduces a distortion into the markets by making price signals difficult to read for investors and businesses alike. The Fed is attempting to lower interest rates artificially. By that, I mean it is not saying that risk premia are elevated because of liquidity since Mr. Sack has already told us it is not performing a lender of last resort role. The Fed is trying to supress risk premia dictated by market forces through its own activity.
Now, in fairness to the Fed, this is exactly what it does with short-term interest rates by setting the Fed Funds rate. However, with short-term rates at zero percent and the economy still not firing on all cylinders, the Fed is telling us short-term rates at zero percent is not enough stimulus. It wants long-term interest rates to be lower than the market-determined rate as well. Clearly, this is a massive attempt at central planning and is, thus, likely to have unintended consequences like excess leverage and speculation.
You can read Ben Bernanke’s views on the QE2 transmission mechanism in my post “The government has a printing press to produce U.S. dollars at essentially no cost“. I take a benign approach to Bernanke’s comments there. However, Marshall is less flattering in “Amateur Hour at the Federal Reserve“. But, go back to QE1 and read Marshall’s piece “Bernanke doesn’t understand the basic economics of central banking” from December 2009. I think this got to the heart of the matter when Marshall told us loans create reserves and warned that QE would have nearly no impact on lending – which proved true.
The loan desk of commercial banks have no interaction with the reserve operations of the monetary system as part of their daily tasks. They just take applications from credit worthy customers who seek loans and assess them accordingly and then approve or reject the loans. In approving a loan they instantly create a deposit (a zero net financial asset transaction).
Bernanke often speaks as if he believes reserves create loans.
Update 14 Mar 2011: I should point out that:
If the entire banking system is at its reserve requirement limit, then the Federal Reserve has three choices:
- refuse to issue new reserves and cause a credit crunch;
- create new reserves; or
- relax the reserve ratio.
Since the main role of the Federal Reserve is to try to ensure the smooth functioning of the credit system, option one is out—so it either adds Base Money to the system, or relaxes the reserve requirements, or both.
-“The Roving Cavaliers of Credit” – Steve Keen’s DebtWatch
I prefer Janet Yellen, the Fed Vice Chair, and the way she recently explained how QE is transmitted to the real economy. She writes:
Some General Observations
It is important to recognize at the outset that conventional and unconventional monetary policy actions bear many similarities. Forward guidance concerning the path of the federal funds rate, for example, is explicitly intended to influence market expectations concerning the future trajectory of shorter-term interest rates and thereby affect longer-term interest rates. That said, standard monetary policy actions also typically alter not just current short-term rates, but the anticipated path of short-term rates as well, influencing longer-term rates through the identical channel. In fact, central bankers have long recognized that this “expectations channel” operates most effectively when the public understands how policymakers expect economic conditions and monetary policy to evolve over time, and how the central bank would respond to any changes in the outlook.
The transmission channels through which longer-term securities purchases and conventional monetary policy affect economic conditions are also quite similar, though not identical. In particular, central bank purchases of longer-term securities work through a portfolio balance channel to depress term premiums and longer-term interest rates. The theoretical rationale for the view that longer-term yields should be directly linked to the outstanding quantity of longer-term assets in the hands of the public dates back at least to the 1950s.(2)
Each of these policy tools tends to generate spillovers to other financial markets, such as boosting stock prices and putting moderate downward pressure on the foreign exchange value of the dollar. My reading of the evidence, which I will briefly review, is that both unconventional policy tools–the use of forward guidance and the purchases of longer-term securities–have proven effective in easing financial conditions and hence have helped mitigate the constraint associated with the zero lower bound on the federal funds rate.
What she is discussing is something called the expectations theory of interest rates.
It works like this: “long-term interest rates can be expressed as a series of short-term interest rates, such that if you know long-term rates, you can calculate expected future short-term interest rates. This is important because it tells you what people believe the Federal Reserve is likely to do with interest rates in the future.”
The Fed telegraphs how short-term rates will or will not be affected by the real economy and expectations shift accordingly. Therefore, to the degree the Fed is successful in getting long-term interest rates to move, it is because it has adjusted those expectations. That’s how it works.
The reason this is true is market arbitrage. Any market participant could go out into the market and purchases zero coupon treasury strips as an arbitrage against long-term Treasury yield mispricing if long-term rates did not reflect the path of future expected short rates. Let me repeat that: if long-term rates don’t reflect the expected path of short-term rates, you have a sure fire arbitrage opportunity. If the Fed is destined to keep rates at zero percent for the next five years and I am sure of it, but the yield on five-year Treasuries doesn’t reflect this, all I have to do to make money is buy the five-year and sell Treasury strips and leverage that trade up in the Repo market. Isn’t that what some investment banks are doing right now – ploughing their POMO acquired money into a leveraged bet on Treasuries? That is exactly what happened after the first jobless recovery in 1992-1994 before Greenspan caused a huge bear market in Treasuries by raising rates.
I don’t want to gloss over the discussion about risk premia. Clearly, Yellen and Sack are saying they are trying to change private portfolio preferences independent of future rate rises. Meaning that the risk premia for holding long-dated paper is suppressed. And analogously, I assume the risk premium for holding risk assets is suppressed. This is a manipulation of price signals and will create a misallocation of resources.
Look, quantitative easing is an asset swap. The Fed creates electronic credits and swaps them with existing financial assets. If the Fed is buying government paper, it is essentially trading one government liability for another, swapping a demand deposit electronic credit for a longer-dated government asset.
“From the government’s perspective, there is no functional difference between any of its obligations like bank notes, electronic credits, or treasury bills and bonds. As the Ten pound note says, “I promise to pay the bearer on demand the sum of [fill in the blank sum][fill in the blank fiat currency].”
So QE2 Is Equivalent to Issuing Treasury Bills. In actual fact, all QE2 does is drain the real economy of interest income by swapping an interest-bearing government liability for a non-interest bearing government liability. This decreases aggregate demand in the economy. So the real economy effects of QE are to slightly lower aggregate demand. This is offset by changing interest rate expectations, which alter private portfolio preferences, and lower risk premia, leading to credit growth, leverage and speculation, forces which should pump up the real economy. The Fed had intended to lower interest rates via the lowered risk premia. To date, the Fed has lowered risk premia. But this has also provided the tinder for speculation and leverage. Moreover, the Fed has also raised inflation expectations to boot, causing interest rates to rise and working at cross-purposes with the lowered risk premia. Thus, QE2 has only been successful insofar as it has increased business credit and raised asset prices. In my view, QE2 has been a bust as it adds volatility to the system and will have negative unintended consequences down the line.