Quantitative Easing is implemented by the Federal Reserve when they buy private sector assets by creating new reserves. The goal of this policy is to try to reduce long-term interest rates and force a portfolio rebalancing effect that will stimulate economic growth. They do this by buying government assets like MBS and Treasury Bonds.
Since the Fed began doing this many commentators have referred to this as “debt monetization” as the Fed takes a government bond and turns it into money. This is technically correct, but far less scary than it sounds. After all, when the Fed does this they are taking one AAA rated government instrument and simply swapping it for another AAA rated instrument. If you sell a bond to the Fed this results in the Fed giving you a deposit and you forgoing your bond. In an environment with 0% rates that means you’re giving up a higher interest bearing instrument for a 0% bearing instrument. You have precisely the same quantity of assets and less income. In other words, you have more “money” and you have a lower propensity to consume because you are worse off financially.
This is the basic theory behind why we’ve been saying QE could be marginally deflationary in the long-run. It isn’t the same as “printing money” like a budget deficit does. And in fact, it reduces incomes which is money printing in reverse.
When people say the Fed is monetizing the debt they’re working from some sort of Monetarist framework that implies that more money equals more inflation. But the reality is that the instruments they’ve issued as bills, notes and bonds are near money instruments and swapping them out for bank deposits doesn’t meaningfully change much. It’s effectively swapping one money-like instrument for another money-like instrument. And that’s why it’s inappropriate to say they’re “monetizing” the debt.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.
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