I popped over to Reddit to try to help clarify some of the confusion on QE and debt monetization. I think my comments there were a bit more succinct than my previous comments:
Hi Everyone. I saw this link from the site. Hopefully I can clarify the message here since I think it’s an important one.
When the Fed implements QE they are creating reserves and swapping these reserves for bonds (in this case MBS). This is a clean swap of private sector financial assets. Before the bank enters into the QE sale with the Fed they hold the MBS (an asset of the bank). After they sell the bond they hold bank reserves (also an asset of the bank). Their net financial asset position HAS NOT CHANGED. So there’s no “money printing” occurring here. The private sector doesn’t have MORE money after the Fed buys the bonds.
Further, it’s impossible for the Fed to be financing the govt’s spending here because they are purchasing on the secondary market from the Primary Dealers who are REQUIRED to bid at Tsy auctions. The US monetary system is designed in this manner to ensure that the US govt can never have trouble procuring funds from the banking system. So some people might say the Fed is artificially propping up demand by giving the banks someone to sell to, but we know that’s not true because this is what people like Bill Gross said before QE2 ended. He said rates would rise. I said they would not. Rates ultimately fell due to VERY HIGH demand for govt debt (in the absence of this supposed Fed “backstop). So we know the Fed isn’t merely propping up the govt bond market.
I’ve created a page for understanding QE here:
And as always, please see my page on the monetary system if you want a more in-depth look:
…The strangest part about QE is that it’s just open market operations. Anyone who understands how central banking works knows that this is what central banks do. They alter the amount of reserves in the banking system to manipulate interest rates. Usually, they do this by targeting a specific rate in the overnight market. But once they move out the curve a little bit everyone starts claiming the program has magical powers. The funny thing though, is that rate targeting at the short end is powerful because they actually name a rate and challenge the market to move against them. Whereas in QE they just let quantity float and don’t target a price. It’s a highly ineffective form of monetary policy and I think the effects of QE on interest rates are vastly overstated because of this lack of rate targeting.
Reserves are deposits held at the Fed banks. The banks don’t “use them” for anything except interbank settlement of payments and meeting reserve requirements. Think of reserves as cash locked up in a separate market ONLY for banks. It’s commonly believed that banks lend their reserves. This is wrong. Loans create deposits. Banks make loans first and then find reserves as needed in the overnight market or by borrowing from the Fed AFTER THE FACT. Banks are never reserve constrained. They are capital constrained. The money multiplier we all learned in econ class is dead wrong. It’s just not how banks actually operate in the real world. Thank your ivory tower professor for getting this one wrong. 🙂
In QE, if a non-bank sells bonds to a bank who then sells to the Fed then this increases deposits in the non-bank private sector. But that’s like changing your savings account into a checking account. Do you always go spend more just because your bank changes the TYPE of account you have with them? Of course not. You spend based on your current saving relative to expected income. QE doesn’t force more lending, more money printing, more spending, or more anything really. What it does is cause lots of confusion and a portfolio rebalancing effect that forces Wall Street’s traders to shift their allocations up the risk curve to make up for lost yield. That’s about it.
Hope that helps.
See more here.
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.