Monday, August 4, 2014

Impact of QE

This is my third part in my series on money and banking. In my first post on money and banking, I talk about the very basics of money and banking (mainly about loans creating deposits and the implications of loans creating deposits). In my second post of the series, I spoke about the basics of monetary policy and what quantitative easing (QE) is. In this installment of the series, I'll talk about the impacts of the Fed's QE policy. Before I start talking about the impacts of QE, I'll talk about the misconceptions of QE.

There's a common misconception that QE is decreasing the yields on bonds (or equivalently, raising the price). The idea continues that QE stimulates the economy by reducing long term rates to induce borrowing in a very IS/LM-like manner. However, this proposition does not seem to hold empirically. Every single time the Federal Reserve has taken up a QE program, yields on long term bonds have gone up, not down. On top of this, long term rates have continued to stay elevated until after the programs were discontinued. In the case of the QE 3 program, long term rates have consistently gone down as the Fed has tapered its bond purchases. I've showed the chart below which shows how long term interest rates and you'll see that rates have indeed gone up when the QE programs were announced AND stayed elevated until the programs were discontinued. We can clearly falsify the idea that QE reduces long term rates and stimulates the economy by inducing borrowing.
Note: The guys running the Fed think that QE reduces long term rates even though the narrative is obviously false (this is a major problem as they clearly do not understand the impacts and mechanisms of QE).
Note: Long term rates have dropped significantly since the Fed has started tapering and the 10 year is now <2.5%.

QE certainly does impact the economy, but it doesn't do so by reducing long term rates to stimulate borrowing. Recall that QE is simply an asset swap whereby the private sector sees a reduction in its bond holdings and receives cash instead. QE was done after the country hit the zero lower bound when increasing the monetary base has little effect on the short term money market rate of interest, which was already taken down to zero. In other words, QE effectively creates a gigantic pile of cash looking to go somewhere while limiting the amount of bonds that can be held by the private sector.

By reducing the amount of bonds that can be held by the private sector while increasing the amount of cash held by the private sector, investors/traders will naturally shift their behavior by shifting the amount of assets they hold. Basically, QE works by the private sector rebalancing their portfolios. Market participants, all of a sudden, find themselves holding more cash and less bonds. This means they'll naturally want to rotate out of cash and into other assets. QE works by creating a gigantic pile of cash looking to go somewhere while the private sector will be holding less bonds. So QE causes rotation of capital out of certain asset classes into others. Where does this gigantic pile of cash and liquid assets go? It usually flows into assets like equities and foreign assets. Note that if there's a flow of capital into foreign assets, other countries will be receiving capital inflows. So the primary effect of QE is international. The capital flows don't just show up in foreign assets, but investors also rotate into other assets such as equities and high yield debt.

The primary (and most obvious) effect of QE is that it creates capital outflows from the US into emerging markets. It is my belief that much of the boom in asset prices we've seen in emerging markets since 2008-09 has been due to capital inflows from the US supporting their currencies and asset prices. In many of these countries, we've been starting to see asset bubbles and many of these asset bubbles are being driven by the Federal Reserve's QE. In a sense, QE can be considered a form of a currency war.

The second effect of QE is that it has created negative real lending rates (interest rates minus NGDP growth rates), which subsidizes producers at the expense of consumers. In other words, QE actually subsidizes and places upward pressure on US production. Negative real lending rates allow producers (particularly large manufacturers) to have access to very cheap capital which can be used for production. Negative real lending rates, in general, hurt net savers. If we split the economy into three separate sectors (households, businesses, and governments), we see that households are net savers while businesses and governments are net borrowers. Since QE (and negative real lending rates) help borrowers at the expense of savers, QE tend to benefit businesses and governments at the expense of households.

The third effect of QE on the real economy is that QE actually drives up the savings rate. It may seem strange to think that QE hurts net savers while driving up the savings rate, but it's not strange at all. The confusion comes because of the difference between the total savings rate of an economy and household savings--those two are not the same! We must first remember that savings is defined as income not consumed. It's also obvious that businesses and governments consume much less resources than households (S=Y-C). So if we transfer resources from net savers (households) to net borrowers (firms and governments), we will see an increase in the savings rate. Note that this may or may not increase the real debt burden (measuring debt in nominal terms is useless, debt/debt servicing capacity ratios provide much more information)--it depends on the resulting shifts in productivity relative to the debt servicing cost.

Another effect of QE is that it allows the federal government the ability to collect on seigniorage (the real profit from the issuance of currency). As I discussed in my previous post, QE means that the central bank buys Treasury bonds and mortgage-backed securities (MBSs) by creating new currency in the system. The currency in the system shows up as bank deposits or as bank reserves. Note that the Fed gets a return from holding those Treasuries and MBSs while the Fed pays out a certain interest rate on bank reserves (but not on the rest of the currency in the system). Also note that all of the profits/losses of the Federal Reserve show up on the Treasury's cash flow. Currently, the Fed pays out .5% annually on the bank reserves while it gains (much) higher interest rate on the Treasuries and MBSs that it holds. The resulting interest rate spread is revenue that's being collected as seigniorage by the Treasury.

Note: QE has created a serious risk of asset market destabilization. As I previously stated, the point of QE is to gigantic pile of cash that's looking to go somewhere while limiting the amount of bonds available to the private sector. This means there's more cash available and less of that cash is going into bonds (particularly since bond prices are falling during QE). Obviously, there's a real risk of asset market destabilization, which we're currently seeing.


  1. I like your series so far, but...have you read any books by Richard Koo yet?

  2. Likely reason for the increase in long-term sovereign bond rates in the USA during each QE is probably the reduction in “flight to safety” so bond holders seek higher yields in corporate bonds and emerging markets, which thus drive rates down for those higher yielding sectors. The QE programs provide confidence and expectation of a boom for large domestic corporations who are net borrowers (by subsidizing them with lower interest rates) and emerging markets.

    Note also that QE subsidizes large multi-nationals at the expense of smaller businesses yet small businesses provide a majority of the employment. And as you pointed out, the higher long-term sovereign bond rates correlate with the mortgage rates thus the majority of the public is negatively affected.

    Also QE1 and QE3 in the USA recapitalized the largest banks (by buying mortgage backed securities a.k.a. MBS) which had eaten the smaller failing banks which the Fed allowed to fail. Thus QE promoted a “too big to fail” regime that forced smaller banks to become very strict on loan risk going forward thus why lending to small businesses decreased.

    QE2 bought the short-term sovereign bonds, then Operation Twist followed to trade these for longer-term bonds, thus you can see the long-term rates declined significantly, but this caused significant risk aversion which drove up volatility and contributed to the need for QE3. The Fed found QE2 to be too toxic on long-term rates so backed out of it with Operation Twist, then opted for buying MBS again for QE3.

    In essence QE subsidized the bankers who own the majority of the shares of the Fed at the expense of the rest of the banking system. Recent revelations show for example the Fed's favoritism towards Goldman Sachs.

    QE1 halted the panic but further QE did not correlate with a growing real economy.

    QE sustained a negative marginal utility of debt regime thus driving global debt-to-GDP ratios past 313%.

    The resulting humongous imbalances and asset bubbles along with the $700+ trillion in derivatives that have been amassed, means we are sitting on a time bomb of radically greater volatility than in 2008.

    China, Japan, Europe and the emerging markets are turning down. If the central banks attempt another QE on the next collapse contagion, they will find they can’t turn the tide of risk aversion back, because the forces of contagion will be too great because the imbalances have been so radically increased since 2008.

    In short, checkmate. Minsky moment is approaching (ETA 2016).

    1. The other reason that the next contagion is qualitatively different than 2008 is because QE sent massive amount of capital to the emerging markets in the form of corporate bond issues, thus the rest of the world is now short the dollar while as the rest of the world is collapsing, driving capital to the USA driving the dollar higher thus worsening the effects of the emerging markets short dollar position thus sending more flight to safety capital exodus into the dollar. The contagion is a self-feeding snowball now and will spiral into massive volatility that can't be suppressed with another round of QE.

  3. "particularly since bond prices are falling during QE"
    Which bond prices are falling?

  4. Long end Treasuries. See the first chart.

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