Opinion

Felix Salmon

How QE works

By Felix Salmon
November 4, 2010

Gawker’s John Cook asks me a question about how the Fed’s quantitative easing is supposed to work:

So the Fed is going to by $600 billion in U.S. Treasuries. It will presumably buy these Treasuries from private investors and institutions who had already purchased them–in other words, it won’t be handing $600 billion to the U.S. Treasury in exchange for bonds.

The purchases will be in increments of $1 million. Now, the kind of people who own $1 million and more in U.S. Treasuries tend to be people with a lot of money. And that money was kind of sitting there, and for some reason or another they decided to put it into treasuries, right?

So now along comes the Fed and says to those private investors and institutions, “Hey, I’d be happy to convert those treasuries into cash for you!” And they negotiate over price or there’s an auction or whatever, and the investors get their cash and the Fed gets its treasuries.

And so then these private institutions and investors are sitting there with a pile of cash. So why wouldn’t they just buy treasuries with it, which is what they had previously decided would be the wisest thing to do with that money?

The idea is to get those people to spend that cash in stimulative ways, right? But shouldn’t we assume that people who are sitting on large quantities of treasuries are sitting on them for a reason, and would likely continue to sit on them, even if they suddenly came into some cash?

John has a few of the details wrong, but at heart he’s absolutely right. The way that QE works is that the Fed will publish a schedule of how many Treasury bonds it intends to buy and when. It will then go out and buy those bonds from “the Federal Reserve’s primary dealers through a series of competitive auctions operated through the Desk’s FedTrade system.”

In English, what that means is that the New York Fed has a direct line to the biggest banks in the world (Goldman Sachs, Morgan Stanley, Deutsche Bank, etc — 18 in all). And it gets all those banks to compete with each other, either directly or on behalf of their clients, for who will sell the Fed the Treasury bonds it wants at the lowest price. The winners of the auction get the Fed’s newly-printed cash*, and give up Treasury bonds that they own in return.

The people selling Treasury bonds to the Fed, then, are big banks, who are told in advance exactly how many Treasury bonds the Fed wants to buy. As a result, they’re likely to buy Treasuries ahead of the auction, with the intent of selling them to the Fed at a profit. This is pretty much what John said would be going on, only they buy the bonds before the auction, rather than afterwards. Once the banks have made that profit, it’ll get paid out in bonuses to the people on the bank’s Treasury desk, with the rest going to their shareholders. We’re not exactly helping the unemployed here.

More generally, the Fed isn’t going to be buying any more bonds than the Treasury is issuing — so it’s not going to be lifting a lot of holders of Treasury bonds out of their long-term investments. But insofar as the Fed is forced to offer such high prices that investors simply can’t say no, those investors are probably just going to take the proceeds and invest them in agency debt instead from Fannie Mae and Freddie Mac. That debt is just as safe as Treasuries, and it even yields more than Treasuries, to boot.

What’s emphatically not going to happen is that the people who used to own Treasury bonds will take the Fed’s billions and suddenly turn around and spend them buying croissants at their local family-owned bakery. We’re talking about monetary policy here, not fiscal policy: the aim here is to bid up the price of Treasury bonds, which means that the yield on Treasuries will fall, and that those lower interest rates will somehow feed through into greater economic activity. The aim is not to take $600 billion and spend it on stuff in the real economy. That would be a second stimulus, and the chances of a second stimulus right now are hovering around zero.

Which is why Brad DeLong puts the value of buying $600 billion in Treasury bonds at about $7 billion in total, rather than anything near the headline $600 billion figure. The Fed is playing around with interest rates here — that’s its job. It’s not trying to directly stimulate demand.

*I should also take this opportunity to answer a question from CJR’s Dean Starkman, who asks where the money is coming from. The answer is that in a fiat-money system such as ours, the central bank can simply print as much money as it likes. If it wanted, it could literally go down to the local printing press, print out a bunch of $100 bills, put them in armored trucks, and send them over to JP Morgan or whoever sold them those Treasury bonds.** But that would be silly. So instead it simply increases the amount registered as on deposit at JP Morgan’s bank account at the New York Fed.

If JP Morgan had $100 billion in that bank account before, and then sells the Fed another $50 billion of Treasury bonds, then the Fed will just credit that $50 billion to JP Morgan, and the new balance in JPM’s account is $150 billion. Central banks can do that, which is why they’re so powerful. The amount of money in the system has just increased by $50 billion, and the Fed hopes that somehow that increase will feed through into higher inflation. Whether it will or not, however, depends on the degree to which JP Morgan can take that $50 billion and lend it out into the real economy. So far, banks have been bad at boosting their lending. And there’s not a lot of evidence that they’re getting any better.

**Update: Alea tells me I’m wrong on this: it’s the Mint which prints paper money, not the Fed, and all paper money is backed by Treasury-bond collateral.

Comments
13 comments so far | RSS Comments RSS

You seem to be forgetting that QE2 will affect the market price of the treasuries the Fed intends to buy. Banks won’t be able to buy the bonds at $100 knowing the Fed will soon buy them at $102, because the market price will adjust (if it hasn’t already) and because there’s no reason for the Fed to pay more than then current market.

Because the market price adjusts, everyone who owns treasuries benefits (or has benefited). Some of them may sell their treasuries and use the profits to buy croissants at their local family-owned bakery.

Posted by 3oosion | Report as abusive
 

“the aim here is to bid up the price of Treasury bonds, which means that the yield on Treasuries will fall, and that those lower interest rates will somehow feed through into greater economic activity. ”

the “somehow” comes because the goal is to make it unappealing to own safe, riskless assets like Treasuries by bastardizing their price (decreasing the yield) to such an extent that it’s not economical. The Fed wants to FORCE investors into risk assets…

so, the former treasury owners (who sold their positions to the Fed) may re-invest the proceeds in new treasury purcahses, and if they do that, the Fed will do QE3, trying even harder to get the investors to pump money into other asset classes. Obviously, this is already happening (just look at commodities, stocks, corporate bonds). Bernanke’s goal is to get money out of riskless assets and into risk assets. It’s working – there’s no doubt, but that doesn’t mean we’ve fixed anything!

We still haven’t figured out where the economic activity comes from! Bernanke wants there to be a wealth effect, where people feel richer so they then go out and borrow and spend more…. pause… does that sound familiar? Yes kids – that’s correct – that’s what caused the massively destructive bubble we’re trying to re-bubble over right now!!! Borrowing and spending off of falsely inflated asset values! last time it was home values – this time it’s investment portfolios…

it’s all a nice fun game until the fuel for the fire runs out. then what happens?

Posted by KidDynamite | Report as abusive
 

KidD, I’ve been seeing things a bit differently. Am I off base?

My perception is that the Fed is threatening inflation, thus putting real bond rates well into the NEGATIVE territory. Basically they are telling people, “Use it or lose it.” Corporations/individuals must either spend their dollars or accept that they will be significantly devalued. Loaning them to somebody else (at these rates) doesn’t cut it.

If the threat of confiscation isn’t enough to get people to spend money, I don’t know what will.

Posted by TFF | Report as abusive
 

TFF – i think the goal is that unattractive riskless yields (0% savings accounts, for example) force capital into return-seeking asset classes which creates inflation.

Yes, the Fed is “threatening” inflation in some sense, yet everyone knows that they’ve been unable to achieve it. Now they have to Just Do It – if they can’t achieve it with interest rate policy, they will actually physically buy assets and inflate their price!

Posted by KidDynamite | Report as abusive
 

I don’t think that Fed is using the wealth effect argument to justify QE2. It’s too minor in their scheme of things. Besides, if you are primarily concerned with the wealth effect, then you choose less liquid assets, like stocks. HKMA bought HK stocks in ’98 to great effect. TFF, since the most immediate threat prior to QE1&2 was disinflation and defaults, holding cash/near-cash actually looked like a good trade in real terms for a while. Only by having a real threat of inflation can you get people out of the fetal position and lending again.

I agree with Felix that the elasticity of demand for loans at this point is negligible at this point, mostly because corporates have little compelling opportunities and households are deeply under water. Although the fiscal route sucks, it does address the real economy. The really interesting side is what all this does to the EM economies that have lashed themselves to the dollar boat and facing sirens of local inflation.

Posted by Derrida | Report as abusive
 

Something I don’t think I’ve seen anyone mention, but I think is important, is that this also allows Treasury to continue borrowing astronomical amounts of money without spiking interest rates. That borrowing turns into government spending, and that’s where the “printing” actually happens. Treasury exchanges bonds for cash with primary dealers, primary dealers exchange bonds for cash with Federal Reserve. End result is Treasury has cash, Fed has bonds. Now treasury can keep paying unemployment benefits and building bridges to nowhere.

Posted by Hapablap | Report as abusive
 

“… those investors are probably just going to take the proceeds and invest them in agency debt …”

Actually, what the Fed hopes is that the (most) investment will displaced into the (US) equity markets. The idea is that by lowering the cost of capital, projects near the margin of profitability would become attractive.

But as you say, the Fed has no control over what investments are substituted for treasuries. It could be agencies, as you suggest, or it might be that the market views a 5Y treasury to be the best substitute for a 2Y treasury. In that case, the effect would be to flatten out the curve a little further along the term-structure. If the price of risk is not affected by the Fed’s actions (i.e. corporate spreads unchanged), that would still reduce the cost of financing, for those companies in a position to take on leverage.

But there are a number of heroic assumptions here. It might be that investors views are changed by the Fed’s actions such that they invest in BRIC equity markets (“leakage”), or gold, or other commodities.

Posted by Greycap | Report as abusive
 

Isn’t the focus on treasury bond pricing here missing the forest for the trees?

The economically significant aspect of QE is that the Fed is creating $600 bln in fiat money ‘ex nihilio’ and pumping it into the money supply. Treasury bond purchases are just the distribution mechanism. However many parcels of bonds get passed around, the net result at the end of the day is that M0 is $600 bln bigger than it was before.

Posted by McKenzieG1 | Report as abusive
 

I think I agree with McKenzie here. My Money and Banking class was a long time ago, but isn’t the Fed creating high-powered money, that the banks can in turn lend and lend and lend, using the fractional reserve banking system?

To date, the problem has been lack of loan demand or unwillingness on the part of the banks to lend, thus velocity has declined and M2 or M3 or whichever M is real money has not grown.

The Fed is hoping that using helicopter drops of money would eventually pursuade the banks to lend and money supply would increase and thus the economy grows.

Am I missing something here?

Posted by Bernanke | Report as abusive
 

McKenzieG1 has not said anything to contradict the earlier comments. Everybody agrees that the equation is something like:

more money + fixed assets = higher asset prices.

The issue is that relative asset prices can change and if they do it can make a difference to the effectiveness of the program.

Posted by Greycap | Report as abusive
 

purely speaking the supply of publicly avaible tresurys are going to stay the same because the amount of debt issued by tresury over same period equils about the same as deficet

to put this in smaller scale easier to understand terms lets say that you get social secuity check for 1000 dollors and you use that money to buy 5 year tresury bonds the net effect is money just cycles though econmy but if fed buys the bills for 5 year you cant buy them you have to buy something else stocks for instance etc

all the feds doing is preventing the us goverment from needing to burrow from privte sector for funding over next 6 or so months

Posted by sarah333 | Report as abusive
 

Market prices aren’t that efficient. Will cheapen up an issue into treasury auction and bid up into FED. Traders will make money.

I think the money does end up in the middle class. It finances government spending at low rates so the government can borrow more without taking on interest expense allowing more spending into government programs.

Posted by sditulli | Report as abusive
 

Alea is incorrect. The Dept of Treasury’s Bureau of Printing and Engraving prints paper money on behalf the Fed (and netting 4 cents a bill regardless of denomination). The US Mint is a separate Treasury agency that coins money. Coin money is a different kettle of fish, the Fed buys coin from the Mint at face value. The Mint’s costs stay in its Public Enterprise Fund, the Secretary of Treasury sweeps the profits into miscellaneous receipts (31 USC 5136) So every dollar coin that costs 12 cents to mint adds 88 cents to general revenue.

The Secretary is granted authority to mint platinum coins of whatever “specifications, designs, varieties, quantities, denominations, and inscriptions” that he prescribes (31 USC 5112(k)). As we saw with the dollar coin, a coin’s face value bears no relationship to its cost of production. Remember too, coin seigniorage is booked as revenue, not debt. A trillion deficit could be covered tomorrow by the Secretary directing the Mint to coin a $1 trillion piece (or ten $100 billion coins, easier to make change) and then showing up at the drive-in teller to make a deposit (the interest on reserve payments enable the Fed to peg the federal funds rate without having to sell Treasuries to drain excess reserves).

Posted by beowu1f | Report as abusive
 

Post Your Comment

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/
  •