Friday, September 14, 2012

OMG! QE3 To Boost Inflation…Not

The Federal Reserve Open Market Committee yesterday announced a third round of quantitative easing (excerpt; emphasis added):

FOMC Statement

…The Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that inflation over the medium term likely would run at or below its 2 percent objective.

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative

Basically, the Fed is committing to increase its balance sheet size by USD85 billion every month – sounds like a lot, but its actually only about a 11.3% expansion of the Federal Reserve system’s USD2.8 trillion consolidated balance sheet from now until the end of the year.

(Details in the Fed’s plans are available here).

Markets around the world are already beginning to react positively to the spate of good news – first the ECB “unlimited” bond buying program, then the ratification of the EMS a couple of days ago, and now QE3.

There’s a bit of a misunderstanding about what all this means, specifically that people (around here anyway) think that monetary easing – in Europe and the US – will send a flood of newly printed money into developing markets.

I don’t believe that’s the case, as the ECB’s bond buying program will be fully sterilised (no actual money injection). In the case of the Fed’s QE programs, something similar is going on – unlike central banks in more normal times, the Federal Reserve pays interest on excess bank reserves (the IOR policy) kept at the Fed, instituted along with the its liquidity support operations in 2008 and never rescinded.

In operational terms what that means is that, as banks would be indifferent between interest bearing reserves and holdings of Fed-issued securities, sterilisation is implicitly built into the system. In fact the practice of IOR was roundly criticised by many top economists then and since, as it doesn’t actually increase the money supply, despite all the money printing going on.

And that viewpoint has been borne out by the historical data – nearly all of QE1 and QE2 were swallowed up by an expansion in excess reserves kept at the Fed, and not an increase in cash or credit in the US financial system.

What has and will happen however, is what Bernanke is aiming for – lower long term interest rates (the Fed Funds Rate on targets the overnight interbank rate, changes in which are normally then transmitted to longer term interests rates) without an increase in the money supply. There’s ample historical evidence that  in the aftermath of a crisis, bank excess reserve ratios tend to remain elevated for a decade or so.

Moreover, this policy channel would have an effect on portfolio compositions and asset allocations, which is where the “flood of money” is actually coming from – its a rebalancing of portfolios towards higher yielding (read:riskier) assets and away from safe havens. It’s existing money being redirected, not new money going into the global financial system.

Whether you believe that or not, we’re now seeing concerted policy action on a global scale (e.g. China’s investment boost, South Korea’s combined fiscal and monetary stimulus packages) that should see the global economy through at least until this time next year.


  1. WRT to US QE, I'm not quite sure about no money increase. While it's true most went to reserve, but if you observe the M1 and M2 at Fred, there were positive spikes (and no negative spike), suggesting permanent increase in money supply.

    MI q-o-q SA

    M2 q-o-q[1][id]=M2&s[1][transformation]=pch

    (unsure if the q-o-q settings are preserved in those links but if it isn't, it's easily reconfigued on FRED itself)

    I think the the signals from M1 is particularly illuminating. IIRC, excess reserve isn't included in M1, M2.

    1. Hafiz,

      You're absolutely right, but I think that's the wrong way to look at it. You can still get endogenous money growth, without an exogenous monetary injection.

      If Bernanke and the FOMC are right in thinking that the portfolio channel is important (for the US at least), lowering long term interest rates alone would boost credit creation and thus endogenous money supply growth.

      It would be pretty strange if there wasn't money supply growth, because that would mean that the portfolio channel isn't working.

    2. True about endogenous money supply growth, but looking at m-o-m, the big spikes happened during the two periods of the QE. It's hard for me to accept that as coincidence. (Although, looking at past crisis, a spike seems like a guaranteed occurence and I haven't checked why... possibly drastic rate cuts?)

      Another potential hint of increase in money supply is compare excess reserve and the sum of past QEs. Assuming that all of the past QE money is still in the system (judging by the Fed balance sheet, maybe not far fetched?), the sum in excess reserve (between 1.4 and 1.6 trillion) is about 50-60% of the sum of the previous two QEs (which is 2.7 trillion). That might suggest some money did enter the system.

      Besides, if Bernanke and gang were only doing implicit sterilized operations, they would just need to expand Operations Twist in a big way.

    3. Okay, forget what I wrote about m-o-m and coincidence. I just realized it doesn't negate the endogeneity point your raised.

    4. Should have thought of this earlier - the details of QE1 and QE2 are a matter of public record:

      The interesting point is that QE2 kicked off just as the Fed was withdrawing its liquidity support operations, so quite a bit of the asset buying was really changing the composition of the Fed's balance sheet but not necessarily its size.