Wednesday, November 3, 2010

Deconstructing QE2: it's less than meets the eye

Today the FOMC told us they are prepared to buy an extra $600 billion of Treasuries over the next 8 months—about $75 billion per month. They did not commit, however, to buying this much: "The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability."

In other words, the Fed is not going to make a big monster purchase of Treasuries that would flood the system with new money. They are going to dribble it out a little at a time, and might even decide to end the program after a month or two, should the economy and/or inflation show signs of picking up. This is almost exactly what I was hoping would happen.

With $75 billion in new purchases per month coming on top of the purchases needed to offset maturing MBS, the Fed will be buying roughly $110 billion of Treasuries a month, which, curiously, happens to be almost exactly the amount needed to fund the Federal government's budget deficit—the federal deficit over the past 12 months was $1.295 trillion, or $108 billion per month. Hmm.

If this were Argentina in the 1970s and 80s, such a program would undoubtedly lead to a huge increase in inflation—it's debt monetization, pure and simple. Back then, Argentina's government essentially ordered its central bank to print up enough money to cover the government's budget deficit. The government paid its bills with newly-printed cash money, and that money became like a hot potato that people tried to spend as fast as possible. (Holding on to currency that loses a significant portion of its value every day is equivalent to paying a tax to the government, so people naturally try to spend the money as quickly as possible, in the process acquiring things that won't lose their value—such as dollars or gold or euros or commodities or real estate.) I should know, because I lived there in the 70s and vacationed there often in the 80s. In the four years I lived there in the late 70s, inflation averaged about 7% per month, or about 125% per year. During one 3-week stay in the mid-80s, I got the distinct privilege (for an economist) of witnessing a staggering 200% rise in the price level. That works out to about 9,000% per year, enough to qualify as true hyperinflation.

But this isn't Argentina. The Fed is not going to print up a billion $100 bills every month and ship them over to Treasury. Instead, the Fed is going to buy $75 billion of Treasury securities each month on the open market, and it is going to pay for those purchases by crediting banks with newly created reserves. This is the way the Fed financed its first quantitative easing, with the purchase of $1.3 trillion of Treasuries and MBS—bank reserves increased by $1.3 trillion. Note, however, that even if the Fed buys $75 billion of Treasuries for the next 8 months, that will barely add up to 4% of GDP. Printing an amount of money equal to 4% of GDP is not going to greatly upset the inflation applecart.

Moreover, the reserves the Fed creates to buy the Treasuries can't be spent the way $100 bills can; they only exist at the Fed. They can only turn into "spendable" money if the banking system uses the extra reserves to create new loans (thus increasing bank deposits) or turns some of those extra reserves into currency. And either way, that process depends on the system wanting to borrow more money and/or hold more currency.

With QE1, we know that the banking system was content to let almost all of the $1.3 trillion in new reserves sit at the Fed, where they conveniently earn a bit of interest. Banks were extremely risk averse, and their demand for rock-solid cash-like assets was huge, so they were happy to hold on to all the new reserves. The rest of the world was also very risk averse, and there was a lot of deleveraging going on. In other words, the demand for new loans was very low at a time when banks were very reluctant to lend and the demand for money was very high. Result? The Fed ended up satisfying almost everyone, and the financial crisis passed without any meaningful inflationary consequences.

With QE2, we may find that the newly created reserves end up being more than the banking system is content to hold. If so, banks may use some or all of the new reserves to increase deposits and further expand the money supply (note: M2 already has grown by almost $1 trillion since mid-September '08, and one dollar of reserves can support up to $10 in new deposits). Or it may be that the world decides to exchange some portion of the new reserves for currency (note: currency in circulation already has increased by $130 billion since mid-Sep. '08, and one dollar of reserves can support one dollar of new currency). So we'll need to watch M2 and currency in circulation even more studiously going forward, in order to gauge how QE2 is impacting things.

With today's clever announcement, the FOMC has not only indicated that it is willing to undertake a substantial QE2 program if the need arises, but it is also giving itself some time to make sure that nothing gets greatly out of hand. There is no need to panic—yet.


John said...


They are also reminding the markets they will do what it takes to restore prosperity. It is very hard to bet against this recovery for long. It is slow but things are getting better, not worse.

Watch the financials. They are behind most of the other sectors and they bounced on the QE news today. PMs are almost universally underweight the group. If they decide to just evenweight them, it will mean a big move.

Public Library said...

"How an Economy Grows, and Why it Crashes"

However you want to spin it, it is the Federal Reserve crediting something out of nothing. One big ponzi scheme running on its last legs.

TMcM said...

Hey Scott, love your blog! Wondering if you can explain "Moreover, the reserves the Fed creates to buy the Treasuries can't be spent the way $100 bills can; they only exist at the Fed." ... very slowly and carefully.
If I am a bond investor who sells my Treasury bond to the Fed, then am I not able to "spend" the money on whatever I wish to?

Rick said...

In his Washington Post column today, Bernanke states that the Fed will spend $600 billion. He does not use the "up to" qualifier.

Anonymous said...


I can not tell you what a pleasure it was to stumble upon your blog. Your analysis is outside the normal blather one finds in more public venues and your wealth of data and charts coming free of charge is unparalleled in my personal sphere. For all that and more I say "thank-you for sharing"!

What brought me to your blog was a search for "current velocity of M2" as I am a monetarist believer at heart and am keeping a sharp eye out for the earliest whiffs of inflationary pressure which brings me to 2 pertinent questions:

1) Where can I find M2 velocity on the web?

2) How do you feel about recent analysis arguing that inflation is being foisted upon developing nations via QE2 money flows and that this in turn is pushing uncontrollable inflationary pressures into the commodity/ producer price pipeline?

Thanks again for sharing such erudite analysis with the public! I hope you'll keep it up and let me know where to send my donation.

Joe in NY

Scott Grannis said...

TMcM: I'm glad you asked that question, because it's a very important point and needs to be clarified. Of course an individual can sell a T-bond to the Fed and then go and spend the proceeds. But for that to happen the bank in whose name the Fed is holding the newly created reserves must either redeem the reserves for cash, or use the reserves to create a new deposit in your name. That results in an expansion of the money supply, at least temporarily. Next you have to ask what happens with the money you spend. If, in aggregate the economy does want to hold more cash or more deposits, then the money you spend will find its way back to the Fed in the form of reserves. That's what happened to the first QE of $1.3 trillion, and it could happen again. That's why we need to watch the monetary aggregates very carefully going forward to see what is happening with the extra reserves.

Scott Grannis said...

Sunvox: Thanks for your kind words. I don't know of an easy source for M2 velocity. I just calculate it myself by dividing nominal GDP (from BEA) and M2 (from the Fed). I think it is very clear that easy money in the US is turning up as higher inflation in other countries, particularly those that either peg their currency to the dollar or those that are in the dollar orbit. A weak dollar is almost certainly pushing commodity prices higher. I've had many posts on this subject over the years.

Efi Pylarinou said...

Great clarity. Especially, the paragraph about how the QE2 at the Fed can turn in to "spendable" money.

I would like to add that banks not only need to make new loans but also to refinance outstanding loans (they have been reluctant to do so and have created a GRIDLOCK and the Fed money hasnt TRICKLED down to the consumer).

Also, I would like to clarify that in reality it wouldn't be the Fed shipping money to the Treasury (as you mention in 5th paragraph). The printing machines (mint factories) belong to the Treasury which is government owned (unlike the Fed).

In conclusion, Argetina did turn the money presses and directly financed their budget deficit (i.e. used the new bills in government spending). The US is using a trick of increasing the bank reserves and hopes that this will trickle down to the consumer.

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