Tuesday, March 29, 2011

The end of QE and what it means for the market



How QE works.

Whenever Quantitative Easing is mentioned in the media we hear a lot of commentary about “pumping money in” or “injecting liquidity.” Critics decry the money printing by the central bank, etc.

It’s all wrong.

I’m telling you this not that you’ll ever get into one of these discussions with your friends (you may) or even if you did, whether you’d be able to convince them of the fallacies of these arguments, but sometimes it’s just fun to know stuff.

A lesson in QE.

The term quantitative easing applies to a policy whereby the central bank, in this case the Fed, purchases assets (usually government securities) to expand the level of reserves in the banking system and, where desired, target a lower interest rate somewhere along the yield curve.

In the recent QE that was announced last summer, the Fed desired to bring down the interest rate on bonds and so it bought 5yr and 10yr Treasuries.

These Treasury purchases are done in the secondary market with the Fed buying from the public. The Fed doesn’t buy from the Treasury (it’s often misstated as that being the case). In fact, the Fed is precluded by statute from buying bonds directly from the Treasury.

When the Fed buys the bonds it “pays” by crediting the seller’s bank with reserves. Bond purchases (or any asset purchase) results in an addition of reserves to the banking system. Bond prices rise as a result of the Fed’s purchases and yields (which move inversely to bond prices) come down or, at least that’s the intent.

Is the Fed injecting “liquidity?”

No. There is no “liquidity” being injected anywhere.

That’s because all that’s occurred is an asset swap—a Treasury for a reserve balance. Both are exactly the same thing in that they are dollar denominated liabilities of the Federal Government, the only difference being their term and the interest rate they pay: Treasuries have some term, i.e. 2yr, 5yr, 10yr, etc while reserves are zero maturity. Both pay interest, but at different rates.

Therefore, when the Fed conducts QE, it strips the public of one asset—a Treasury—and replaces it with another—a reserve balance. No new money is created.

Is this hyperinflationary or even inflationary?

You can clearly see that it is not. It does not create any “new money” as, say, government spending would. All it does is change the shape of the yield curve, i.e. change the net duration of the financial assets held by the public.

Why did commodity prices run up, then? And why did the dollar tumble?

Perception, pure and simple. There is a belief that QE equates to the Fed “printing money.” Investors and traders act on that belief and push up the prices of commodities and they sell the dollar.

Why didn’t the Fed’s plan result in lower bond yields?

Part of the reason is because QE was widely perceived as being stimulative and a lot of economists started ratcheting up their economic growth forecasts. Bond yields rose on those forecasts.

Another reason why QE did not bring yields down is because the Fed decided to limit the program to a specific QUANTITY of bonds rather than target a specific rate itself. In other words, if the Fed wanted the 10yr to be at 2.0%, say, it should have stated that target and buy as many bonds as necessary to hit the target and then maintain it. This is how it sets the Fed funds target. Instead, the Fed said it would buy $600 bln, without knowing whether or not that would be sufficient to get to its desired rate.

(Now you know how to set rates, in case anyone asks you to run the Fed one day. ;))

What happens now that QE is ending?

Probably nothing.

Operationally, the Fed will stop buying bonds and crediting the banking system with reserves. Rates may move higher because the Fed will not be in there buying, however, to the extent that market participants feel “stimulus” is being removed, bond yields may actually come down. And since QE adds nothing to economic demand, the end of QE takes nothing away, either.

Furthermore, if investors feel that the removal of QE will result in less “inflationary pressure” from the central bank, commodities, gold and oil may come down and the dollar may go up. If so, all this will do is change the composition of the market’s leadership.

49 comments:

Joe said...

Awesome post, Mike. I was just talking about this with someone and wasn't clear on some of the details, this post clarified it.

Tom Hickey said...

Great explanation, Mike.

As you point out, perception is reality. QE 1 & 2 were perceived as inflationary (NOT) and the markets responded. If that is so, and I suspect it is, then we would expect markets to perceive that the ending of QE is "taking away the bunch bowl," as it does with rate hikes.

That should sober equities, which seem to be more momentum-driven now rather than value-driven. The markets seem to be giving huge credence to "green shoots" and not discounting obvious drag, like a housing double-dip and unrest in MENA. I think that as QE ends, so will the vapid euphoria.

Adam said...

"Why didn’t the Fed’s plan result in lower bond yields?

Part of the reason is because QE was widely perceived as being stimulative and a lot of economists started ratcheting up their economic growth forecasts. Bond yields rose on those forecasts.

Another reason why QE did not bring yields down is because the Fed decided to limit the program to a specific QUANTITY of bonds rather than target a specific rate itself. In other words, if the Fed wanted the 10yr to be at 2.0%, say, it should have stated that target and buy as many bonds as necessary to hit the target and then maintain it. This is how it sets the Fed funds target. Instead, the Fed said it would buy $600 bln, without knowing whether or not that would be sufficient to get to its desired rate.

(Now you know how to set rates, in case anyone asks you to run the Fed one day. ;))"

Doesn't this really mean that QE is always happening but just to control the Fed Funds rate?

Tom Hickey said...

OMO uses repos, POMO (QE) uses purchases. Both increase bank reserves.

Mike Norman said...

Adam:

The term "quantitative easing" is used when the funds rate is already at zero or effectively at zero. But, yes, the mechanics are the same.

Matt Franko said...

And remember the FRB NY never hits the offered price for the bonds they buy.... so imo QE2 actually has been RAISING interest rates, cet. par.

The Fed is buying on a scale DOWN... the lower the price the more they can buy with their fixed amount ($6B) of daily purchases.

Resp,

Tom Hickey said...

Ed Harrison, The QE Trade Is Officially Over

Mike Norman said...

Matt,

You are right. If you look at the FRBNY weekly sales data, there is always a minimal amount purchased, but four or five times that amount has typically been offered. They're CREATING the selloff!! What a bunch of dunces!!

TomatoBasil said...
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Matt Franko said...

Mike,

This is what you said a while back..they are using quantity not price... it's like they (Fed) are enjoying taking the buy side of the speculative sell orders...

So the Fed is happy to be buying from Bill Gross, Jimmy Rogers, etc... at ever lower prices as they think they are "getting a good deal for the taxpayers" so the Fed keeps lowering their bid... buying on a scale down (with basically UNLIMITED funds available!).

Lately it seems bond prices have firmed in the face of the Japan thing and the Arab unrest... but as of now we still have another 3 full months of QE2, $6B/day. If the Japanese can get their nuke situation nailed down over there soon and the Arab areas settle down for a while, perhaps the Fed engineered bond sell-off can continue....

Resp,

Musgrave said...

I don’t agree. Isn’t cash is more liquid than Treasuries in that you can buy houses, cars, etc with cash but not with Treasuries?

Also, when a central bank does QE, this is essentially a new buyer entering the market for securities, which raises the price of securities. That raises the value of the private sector’s net financial assets, which induces the private sector to spend.

Thus Mike Norman’s “simple way to pay off the national debt” (previous post) would certainly work, but it could be excessively stimulatory, i.e. inflationary. Thus it might be necessary to mix the latter with a DEFLATIONARY way of paying off the debt, i.e. raise taxes and use the money collected to buy back Treasuries.

Matt Franko said...

Ralph,

Yes I understand that approach as a new buyer would perhaps bid up the price of things. But Mike had this fellow Steve Briese on when he had his show and Steve has studied commodity market dynamics for years and he wrote in a book:

“Although it is true that commercial traders typically buy at bargain levels, and sell at premium prices, you may not be able to afford every bargain, especially as they become bigger bargains. Commercials are negative-feedback traders; they typically buy on a scale down, and sell on a scale up. But they have double protection from the losses that can mount from holding a position through an adverse move. With the belt and suspender security of deep pockets and offsetting cash positions, commercials can add to a long position on a scale down(or a short position on the way up) with near impunity while margin calls are doing in lesser traders. Speculative traders enjoy other trading edges, but regardless of size, speculators have finite leverage limits. (Think LTCM, Tiger Funds, Amaranth Advisors..) For most of us, better results will accrue from buying the moment the commercials quit buying. It is rare to see commercials stop buying before prices hit a bottom.”

I think what Steve B is saying is that deep pocketed market participants who are hell bent on buying (he calls 'commercials') can exacerbate/complement speculative selling and actually help prices fall further than otherwise, as the further the price falls (DOWN) the more they buy (SCALE) .... he recommends waiting to buy until after these types of buyers exit the marketplace.

Mike has been on several futures exchanges so perhaps he can comment...

I dont think the Fed of course looks at it this way. Steve B's observation here is very nuanced.

Resp,

Mike Norman said...

Musgrave:

The difference is minute. You can compare it to shifting your money from your savings account to your checking account. Even if the money is in the savings account, it represents the same purchasing power. Moreover, that money was likely in the form of cash to begin with and you made a decision to put it in the savings account. In other words, if people hold $14 trillion in Treasuries (which they formerly had in cash), there is no reason to assume they will run out and buy stuff if their Treasuries are taken away in exchange for cash.

Tom Hickey said...

Matt, traders of old called these "the accumulation phase" and "the distribution phase." It's the wave motion of Big Money. Smaller traders have to surf those waves, but hitting the crest and trough is tricky.

AP Lerner said...

Good post. One point I would add, is, QE is taking yield, income, and duration out of the private sector. Bond managers such as myself are forced to look for duration and yield in other asset classes. For example, normally, I would prefer to add duration with treasuries. Instead, I'm buying corporates, or other risk assets. As this trade happens over and over and across risk assets, some assets (like commodities, possibly?) start to get bubbly. This is the portfolio rebalancing effect Bernanke has mentioned before.

So yes, QE has exactly zero impact on the real economy, but is definitely distorting asset prices.

Musgrave said...

Mike’s point just above is a good one. But there is a countervailing point: the better the availability of interest earning Treasuries and deposit accounts, the bigger the stock of (checking account + deposit account money + Treasuries) the private sector will hold.

So if that availability is reduced, the private sector will attempt to dissave cash, which is stimulatory. But how big this stimulatory effect would be, I’ve no idea.

Tim said...
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Tim said...
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Tim said...

"When the Fed buys the bonds it “pays” by crediting the seller’s bank with reserves. Bond purchases (or any asset purchase) results in an addition of reserves to the banking system. "- Mike Norman

Is it fair to speculate some sellers purchase securities and/or commodities with the newly credited reserves after selling the bonds to the Fed? Thus couldn't these alternative investments be part of what is fueling the market? -Tim

Tom Hickey said...

Tim, bondholders sell bonds when an indifference level is reached, that is, bond prices rise to the level that they are indifferent to holding bonds or something else. At this point portfolio composition begins to change as people shift out of bonds into other savings preferences iaw risk-weighted expectations for gain.

Mario said...

great post. But it seems to me tim's point is important...I mean isn't this likely how equities have blasted since Nov? and PM's? and comms?

I mean it's kind of obvious no? I am not calling foul or anything (although it is interesting that the Fed now states that banks like JPM have gotten "healthier" and can now increase dividends...but nobody is borrowing so how are they getting so much more propped up?...I also heard that JPM just got approved for a vault through COMEX in just 2 days which is outside of regulation policy which says 1-2 months for physical verification and so likely shows they have no physical silver...again crazy shit imho but I am not a metals freak or anything like that).

I am just saying couldn't the end of QE and this larger "checking account" (vs. savings account) for banks change these "indifference levels" as you like to refer to it? I mean what if the Fed actually knew all of this about QE2...they just did it to get banks even more of a prop while all of us just got fooled but went along for the rally anyway? Surely they know wtf they are doing in QE2. I have a hard time believing the Fed is confused about how they operate POMO and OMO...I am more apt to believe they are public relations GENIUSES and in favor of the banks and betting that no one even knows what the heck QE2 is actually doing anyway...which seems to be true too btw.

Mario said...

QE2 did encourage large bond holders to re-evaluate their investment portfolio and therefore deploy large amounts of capital quickly into various other asset classes other than bonds.

You would agree with that wouldn't you?

It wasn't printing money that's for sure...but it did allow for re-allocation of already existing assets. The deflationary effect of lost interest on those bonds in QE2 was clearly made up for by the huge yields in the new investments QE2 encouraged (aka equities & comms).

Tom Hickey said...

But it seems to me tim's point is important...I mean isn't this likely how equities have blasted since Nov? and PM's? and comms?

1. The market perception was that QE would fuel a market advance.

2. The Fed's purchase of tsys meant those selling thought they could make more parking their money elsewhwere, like equities and commodities.

That may be reversing. See Ed Harrison here. Expect Big Money to be distributing as they unwind the QE trade.

Matt Franko said...

Mario,

The Fed is buying at about the same rate as new net Treasury issuance.

IOW the US fiscal deficit is running at about 110B/mo rate and the Fed is buying at about that same rate. So sort of "net" the Fed is not displacing anyone out of their current Treasury holdings "by brute force", in fact ZeroHedge blog has been documenting how Primary Dealers are buying at a new Treasury auction and then 2 weeks later (right after settlement), they are flipping the very same CUSIP # bonds to the Fed. So literally, the Fed is not buying bonds in the "open market", it's a Dealer market.

I lean towards my comment above, where all the debt doomsday people and "printing money" people, and Bill Gross apparently were heavy speculative/sellers at the start of QE2 and the Fed was the large scale down buyer, exacerbating the down move. Bonds seem to have stabilized here. but if the speculators can mount another round of selling, it would seem that the Fed would be willing to be the scale down buyer again for the specs, at least until the end of June when QE2 ends...

Here is a NYT article on the FRB NY QE2 project:

Link_http://www.nytimes.com/2011/01/11/business/economy/11fed.html?_r=2&emc=eta1


Excerpt: “We are looking to get the best price we can for the taxpayer,” said Mr. Frost, a buttoned-down 34-year-old in a striped suit and rimless glasses.

Whether Mr. Frost will reach that goal is uncertain. What is sure is that market interest rates have risen, rather than fallen, since the Fed embarked on the program in November. That is the opposite of what was supposed to happen, although rates might have been even higher without the Fed program.

Mr. Frost’s task is to avoid paying top dollar for bonds that could be worth less when the Fed tries to sell them one day."

Based on what I read: The Fed is trying to lower bond prices. (raise interest rates)

Resp,

Tom Hickey said...

Some Fed official subsequently admitted that the intention was to drive asset prices "higher than they would be otherwise" for the wealth effect, figuring that would stimulate consumption. People spend more the wealthier they are on paper.

Mario said...

"Some Fed official subsequently admitted that the intention was to drive asset prices "higher than they would be otherwise" for the wealth effect, figuring that would stimulate consumption. People spend more the wealthier they are on paper."

exactly! I heard that too...I thin Bernake said that in fact at one point. I don't think they expected the comm rises to happen though...which didn't exactly help that wealth effect! LOL (but not really funny at all!)

"The Fed is buying at about the same rate as new net Treasury issuance."

That's really interesting however whatever the Fed does buy "frees up" PD assets to deploy elsewhere...even if they are still buying bonds now...they were always going to buys bonds today anyway so it's really not a big deal for PD's. But they sure appreciated the "break" so they could pump up other investments of theirs.

Do you see what I mean? I totally agree though either way that no money is printed, etc. I am just saying the Fed may be fooling us who get what QE2 actually is as much as they are fooling the inflationistas.

"Based on what I read: The Fed is trying to lower bond prices. (raise interest rates)"

They are doing that by buying on scale down into bonds right? In other words the Fed is allowing the number of bond sellers to outpace bond buyers? Even if the Fed is stepping in and buying bonds, they aren't doing it enough and in fact are dropping the bid price down as whenever they do step in which creates deeper selling...even though technically they are buying. Is that right? Could this be b/c they want a "nicer" looking bond curve to "fake" people out in thinking our economy is good. A more normal curve wouldn't hurt "perception" right?

Tom Hickey said...

Mario, when the Fed buys back almost the whole tsy issuance as it is, it is effectively instituting the no bonds approach recommended by many MMT'ers. This means that the private domestic sector either has to spend the deficit into the economy or save it in other assets like equities, commodities, RE, etc. The Fed is encouraging all of this in order to stimulate the economy with at least some spending that might not have occurred and increase asset prices to increase the wealth effect. Since most of that was destined for tsys, it will find its way into other assets, financial and real.

Mario said...

Tom,

it we're doing no-bonds in effect and you admit that it's inflationary...then doesn't this show that no-bonds wouldn't work?

What am I missing man? I still haven't read Wray's piece here on it all yet...I need to I know!

http://neweconomicperspectives.blogspot.com/2009/11/what-if-government-just-prints-money.html

also what do you think about the fact that oil being priced in US $ actually does strengthen our dollar and weaken most other nations. Apparently that was how we took down the USSR by driving oil up so high that we basically forced huge inflation on USSR which helped crumble them...apparently Kissinger was instrumental in orchestrating that. I haven't looked into the figures myself too heavily yet but a buddy of mine shared that with me. If oil was no longer priced in US $ we'd probably experience serious inflation...depending of on how oil was then priced after that I guess.

Matt Franko said...

Mario,

Again, short term price movements "up" in certain commodities is not "inflation".

Every technical term has only one definition, and what we are witnessing now is not "inflation".

Tom has pointed out "inflation" is a general price rise. House prices continue to fall. Lumber is in the toilet. Yet some other commodity prices are up from recent lows, yet down from recent 2008 highs, and of course labor is currently cheap, etc. etc..

I posted this on another thread:

If you'd like check out this video that Bill Mitchell is in at the 15:45 minute point of the part 2 video at the link below, he and Warren Mosler talk about the concept of "inflation" in a modern monetary environment. "Inflation" is not so simple a concept to understand. (for me anyway!)

Link_http://bilbo.economicoutlook.net/blog/?p=12089#more-12089

resp,

Mario said...

Matt

you're totally right dude and I know that already....I can't believe I said that!

I guess my point is that it is proven now that going to "no-bonds" would free up assets of large investment portfolio's to "do with as they please" which will very likely create bubbles somewhere. Call it inflation or not...it'll create bubbles though...or at least it could...again I still haven't read Wray's piece on no-bonds which I need to.

Tom Hickey said...

Mario: t we're doing no-bonds in effect and you admit that it's inflationary.

I'm saying that it is not inflationary, because it would not materially affect desire to spend.

No bonds would increase the demand for other financial instruments. This would depress the yield of corporates and reduce the cost of investment. It would also likely lift equities, providing more investment through secondary offerings. It would increase risk saving risk slightly, but that could be spread.

Tom Hickey said...

Mario, the world is facing an energy crisis. We have to deal with this before it becomes a crippling supply problem. Increasing the cost of oil, especially in the US, the major user, is good for funding alternatives and spurring innovation. The US is lagging here in part due to oil subsidies.

Tom Hickey said...

Mario, bubbles from without no bonds. There is no reason to think there would be more bubble with no bonds. Bubbles form due to irrationality — the greater fool theory of speculation.

Mario said...

Tom,

This would depress the yield of corporates and reduce the cost of investment. It would also likely lift equities, providing more investment through secondary offerings.

these are all good things that would spur growth as less funds would be directed to bonds and therefore free to go elsewhere. I agree with you there. I am not saying that is bad b/c it could be productive in real terms but more than likely it would just be more economic rent as you define it as they would put that money into investment vehicles rather than actual production. Don't you think that is a valid assumption based on past performance? Large PD's will put money into investment vehicles that otherwise would have gone into bonds at auction back when gov. spending had bonds tied to it.

I am beginning to think the US sees higher oil prices as in their favor b/c it forces other nations to stockpile US $ to be able to afford oil...and they all need oil. This increases the value of the US $ and only strengthens us a the world reserve currency which the US as a nation thinks is good. I'm not saying it needs to be that way, but I do think that without the US $ as the reserve currency, we'd probably have a pretty atrocious exchange rate internationally. Don't you think that's valid? If everyone didn't need US $ for oil anymore then our currency would inflate rather significantly as they unwound their US $ holdings. That seems valid to me...where am I off there?

I think if we're going to see a real revolution in energy it might actually come from outside of the US for these reasons...possibly the EU or even Brazil. That would be super cool imho...if only we'd jump on board...if only.

Mario said...

Tom,

check this out I just saw this from a buddy of mine....this is what Israel is doing...and this is a Palo Alto based company I believe:

http://www.engadget.com/2011/03/31/israel-gets-its-first-ev-battery-swap-station-makes-charging-st/

Also check this out...what if we did this:

#1. Allowed the Treasury to run a deficit with the Fed (aka no more bond issuance REQUIRED).

#2. Stopped selling bonds at auction to PD's...allowing PD's to re-deploy huge amounts of cash wherever they want...likely to economic rent but that's no matter at this point.

#3. THEN the Fed/Treasury can buy/sell bonds to PD's as one more way to monitor inflationary pressures in the market from all that extra capital out there.

In this way, we'd have 3 main ways to tame inflation...fiscal policy, monetary policy, and buying/selling bonds at auction to PD's.

What do you think?

Tom Hickey said...

What is important to me is to break the illusion that government finance is the same as household finance when it is actually inverse, to get rid of a smal group of technocrats running monetary policy and end cb political independence, to remove all obstacles to the US taking full advantage of the operational reality of the current monetary regime, and to tax economic rent. We can argue over the details later.

Mario said...

I agree 100% with the household analogy. I am not really upset at all with "technocrats" as you are and I am upset but to a lesser extent than you about economic rent, however I do agree with in that regard.

I do think though that it's in these details that are going to convince people to any real changes. It's like what the Beatles
say in their great song Revolution:

"You say you got a real solution
Well, you know
We'd all love to see the plan"

LOL!! :D

Tom Hickey said...

Mario, as I've said, I am not an economist. I'll leave the details to people who understand the details.

Tom Hickey said...

I am not really upset at all with "technocrats" as you are

When you are living in a globalized world whose money and finances are controlled by central bankers working through national and international institutions you will be. But it will be too late, then.

Mario said...

Mario, as I've said, I am not an economist. I'll leave the details to people who understand the details.

I think you got the goods man!!! I think you can go for it. As Virgil says, "Fortune favors the brave!" ;)

When you are living in a globalized world whose money and finances are controlled by central bankers working through national and international institutions you will be. But it will be too late, then.

Isn't that how it is now? Isn't that how it would be if the Fed/Treasury were one? Isn't that how it would be if the Fed was dissolved and the Treasury was last man standing? Someone needs to run this stuff man...wouldn't those guys, whoever they are, be "technocrats"? The Fed guys just buy/sell tsys and deal with interest rates on computer screens. "Technocrat" holds strange implications that I don't think exactly apply to that function. And the higher-up Fed guys look at and discuss forecasts and models to see if inflation is coming down the road to combat it as necessary. Yeah I admit these dudes are serious Public Relations gurus and yeah I'd love a piece of that 6% annual divvie too but man nothing's perfect. What's the big deal? They don't control everything...fiscal policy is in play as well. Someone has to do this stuff. You can't just eradicate interest rates or something. The institution itself seems solid to me...personally I think we'd be WAY WORSE OFF if we let "the people" elect economists at the Fed/Treasury...omg that would be insane!! We'd have Ron Paul in there before you knew it destroying everything!! We don't elect the judges on the Supreme Court either remember...the President and Congress do that...I believe in a very similar manner to how they elect the Fed chairman.

Tom Hickey said...

If you think that Bernanke and Geithner conspiring to load up trucks of public funds for Wall Street, I don't. These guys have given away trillions so far with waves of the magic wand.

Mario said...

agreed. But those issues aren't b/c of the Fed (at least imho)...they're b/c of the people in those positions in those institutions. It's rampant corruption across the board of the higher echelons in nearly every industry and political arena in the USA. It's insane and corrupt and contemptible. Agreed. But the cause isn't the Fed system (imho)...it's the people. Corrupt people can destroy anything...no matter how perfect. Change the people in there, change the culture, experience, results, etc. Other than the Bernake Put as Prag Cap likes to call it...I think Ben is doing a fab job to give him credit. At least he's no baron-wanna-be like Greenspan!! Bernake actually does care about us.

Just my thoughts.

Mario said...

and anyone reading this can also go and sign this petition that I created anonymously...it is demanding a new amendment to the constitution that puts terms limits to all congressional reps to 12 years max...just like how Presidents have 8 years max. We need new blood regularly in DC!!!

http://signon.org/sign/congressional-reform-2?source=s.fwd

I saw you signed Tom that's awesome man! ;)

Tom Hickey said...

Mario, Geithner can't go fiscal without Congress and he knows it. But he is using the back door to the Treasury as much as he can. Bernanke is using monetary to beef up the banks and prop up the RE market. Both are also conspiring to cover up the actual financial position of the big banks and to cut them favors.

Geithner and Bernanke are both working at putting as much of financial burden on the public as they can, just as Congress and the states are now making the public pay for the real economic crisis that Wall Street created. This is a vast transfer of wealth from the middle and bottom to the top, thanks to our one party state controlled by the elite. It is shameless.

Mario said...

well considering the way Bernake has been talking as of late about how the deficit is high, blah, blah, blah and how he's not really stepping up and just explaining the way non-government nfa relates to government spending...yeah I have to agree with you there for sure.

You may be right. You may be right. ;)

Cantab83 said...

Is it really true that QE is not inflationary? The problem I perceive with the analysis here is that it only looks at QE in isolation and not in combination with the actions of the commercial banks and the government (which is presumably able to issue more bonds as a result of QE).

In the case of the banks, is it just an asset swap? Suppose the banks don't want their reserves at the Fed increased. If they do, then they would have done it anyway, and so as far as I can see all QE does is substitute voluntary reserves for compulsory ones. The banks are then free to use cash that they would have deposited on reserve at the Fed for other things, like investing in equities or commodities and so pushing up those asset prices. If the banks didn't want their reserves increased, then surely they will compensate by reducing their own stockpiles of cash and use that for their investments, won't they? Either way, it seems to me that the net result is that commercial banks will have more cash available to spend, and some of this will end up increasing equity markets etc. Thus the rise in commodity/equity prices is not just down to sentiment in the market as far as I can see.

As for the stimulus argument, well doesn't any stimulus come from the federal government? If QE reduces bond yields, then the federal government can issue more bonds, can't it? And won't that will stimulate more economic activity? Isn't that in effect injecting liquidity into the economy?

I would be interested to hear other people's views on this.

Tom Hickey said...

For QE to inflationary, it has to stimulate spending to the point of a continuous general price rise, including the price of labor. The point of QE is that unemployment is in the tank, the overall trend is deflationary due to massive delevering, and people wealth has been decimated, reducing the desire to spend.

Asset appreciation in some asset classes is not inflation. Relative price volatility (food, energy) is not inflation.

The proof that QE is not inflationary is that the purpose of QE is to get some inflation going and it hasn't — because there is no transmission mechanism from increasing bank reserves to bank lending or consumer spending.

BTW, QE doesn't "force" or "compel" anyone to sell tsys. People sell because the Fed is raising the price to the indifference level, and so some people become indifferent to holding tsys.

Cantab83 said...

@Tom Hickey

I assume your last comment was in reply to my comment. If so then thank you for the response.

You said:
"...there is no transmission mechanism from increasing bank reserves to bank lending or consumer spending."
I agree. No amount of recapitalization of the banks by the Fed can force them to lend to consumers and businesses if they don't want to. However, my point is that a necessary by-product of this policy of QE is that bonds are being removed from the bond market. That leaves a financial space into which the federal government can sell new bonds to finance a larger deficit, and it is from that deficit spending that additional economic stimulus could come.

I suppose my query regarding the issue of inflation emanates from this statement in the original article from Mike Norman:
'(QE) does not create any “new money” as, say, government spending would.'
My point is that I think QE does allow for more government spending, and probably leads to it. If so then surely it does create new money, doesn't it? It just doesn't come directly from bank lending; it arises indirectly from government spending. I therefore see these two measures (QE and government spending) as being causally linked, or at least being two halves of a coordinated policy.

I am also inclined to disagree with Mike Norman's interpretation of the rise in commodity prices.
Again I do agree that this is not real inflation. It is a temporary asset bubble. The question is what is driving it? I don't believe it is all due to market sentiment, though some of it might be. Or I could be wrong and it might all be. But I think it could be because the banks and other investor have new money at their disposal that they wouldn't have if it were not for QE. That money is looking for a home and that home is commodities. As I pointed out, I believe this money comes from capital that they would have otherwise have had to use for building up their reserves, but now because of QE they don't need to. The Fed has done the job of increasing their reserves for them.

I agree that QE is not creating inflation now. The problem in the US economy was deflation and QE is designed to counteract it. My point is that QE adds inflationary pressure to a system to cancel deflation and thereby generate price stability in the short term. The price inflation could come later when the economy starts to recover and strong growth returns. That though is for the distant future.

Tom Hickey said...

Basically, QE adds nothing that is not already there. It doesn't change nongovernment NFA when the Fed buys tsys. However, if the Fed pays more for tsys than they would be worth otherwise, then there is some stimulus. Moreover, if the Fed buys other assets like it did in QE1, paying more for them than they were worth, this is a fiscal dimension of monetary policy and does add to nongovernment NFA.

There is no doubt in my mind that QE 1 & 2 has increased asset appreciation with respect to equities and possibly commodities too. But this has been more from the perception than the truth. Most people do not understand monetary and fiscal and think that the Fed is adding money to the economy when nongovernment NFA remain essentially unchanged.

QE will only have inflationary effects in the future as the economy improves due to misperceptions about it. Unwinding QE by selling tsys back into the economy and draining the excess reserves will return the interest payments on the tsys to nongovernment and that will increase nongovernment NFA somewhat, but hardly enough to result in inflation with everything else going on.

None of this is likely to result in inflation with housing looking to be in the tank for years with the backlog of inventory, and unemployment and underemployment also expected to be persistent, with a new normal U3 of 6-7%.

The big threat is still deflation with global demand contracting and crises popping up like acne on a teenagers face.