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Why QE is not Working….

That was the headline at Zero Hedge yesterday.  I won’t opine on their analysis, but I will just say this: the reason why QE doesn’t work as it’s being implemented is because the transmission mechanism is entirely flawed.   Why is this?  I explained this years ago, but a more succinct answer will suffice.

The way QE works is just like all monetary policy.  The Fed alters the amount of reserves in the banking system and alters the demand for credit.  But the big difference between altering the Fed Funds Rate and implementing QE is that they manipulate prices in setting the FFR.  That is, the Fed sets the price of overnight loans by SPECIFICALLY naming the price of the loans.  This has a dramatic impact on the banking system and the profitability of loans.  But QE has been implemented in an entirely different manner.  It’s been enacted not by setting a price, but by naming a quantity (like, “we’re buying back $600B of US t-bonds”).   So the effect is that banks sell bonds in exchange for reserves, interest rates aren’t altered all that much and the private sector ends up with little change to its balance sheets (QE is a simple swap of assets that doesn’t alter the net financial assets of the private sector).

And because QE works primarily through the lending channels (as monetary policy always does) it hasn’t had much of an impact.  There are a few other side effects of QE (like portfolio rebalancing, wealth effects and mythical psychological effects on economic actors), but the big factor is that it doesn’t induce more lending (because it doesn’t have a transmission mechanism through which it makes credit more attractive – not to mention, in a balance sheet recession, consumers are already shunning credit), but it also doesn’t alter the net financial assets of the private sector.  So the net result – QE just doesn’t do much.   It is, as I said many years ago, “the great monetary non-event”.

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