Quantitative easing has begun

November 14, 2008

johnkemp3– John Kemp is a Reuters columnist. The views expressed are his own –

Quietly, without fanfare, the Federal Reserve has turned on the printing presses.  The central bank is flooding the market with enough excess liquidity to refloat the banking system — and hopes to generate an upturn in both economic activity and inflation in the next 12-18 months to prevent the economy falling into a prolonged slump.

Since the banking crisis intensified in September, the Fed has been rapidly expanding the credit side of its balance sheet, providing an ever-increasing array of facilities to support the financial system (repos, term auction credit, primary discount credit, broker-dealer credit, commercial paper funding, money market mutual fund liquidity and term securities lending).

Total credit extended by the central bank has surged from an average of $885 billion in the week ending August 27 to $2.198 trillion in the week ending November 12.  Credit extensions surged another $142 billion last week alone — mostly in form of increased term auction credit (+$114 billion) and other miscellaneous credits the central bank does not break out (+$41 billion).

Until fairly recently, the expansion on the asset side of the Fed’s balance sheet was matched by increased non-bank liabilities, mostly in the form of higher balances deposited by the US Treasury into its regular and special supplementary financing accounts at the central bank.

Since the Treasury was borrowing this money in the open market by issuing cash management bills, the impact of the Fed’s balance sheet expansion was being fully sterilized.

The Fed was providing liquidity in the narrow sense (helping commercial banks cover short-term funding problems arising from illiquid assets on their books) but not in the broader sense of inflating the money supply (money in circulation plus vault cash plus reserve balances).

But in the last three weeks, something very significant has happened. The non-bank part of the Fed’s liabilities has stopped expanding:  combined Treasury deposits with the Fed plus cash in circulation has actually fallen from $1.517 trillion in the week ending Oct 29 to $1.467 trillion in the week ending Nov 12.

Instead, the Fed’s increased lending to the financial system over the last two weeks (+$325 billion) has been matched by an increase in the volume of deposits the commercial banks are hold with the Fed (+$331 billion).

In other words, the Fed is now lending to the banks, which are now lending the funds back to the central bank.   The Fed is no longer supplying just narrow liquidity needed to enable the market to function.  It is now supplying excess funds (more than the banks need) which are being recycled back into the central bank.

The volume of reserve balances with the Fed, which had jumped from $8 billion at end Aug to $280 billion by mid Oct, has now surged again to a staggering $592 billion in the week ending Nov 12.
The Fed is now very deliberately supplying more liquidity than the banks need (or are willing to lend on to other banks, corporations or homeowners).  By paying a low but positive interest rate on these reserve balances, it can ensure that the federal funds rate remains above zero (currently about 35 basis points) even as it floods the banking system with excess funds.

There are several startling implications:

(1)  The central bank has successfully driven a wedge between interest rate policy (the target fed funds rate) and the quantity of money created (cash plus reserve balances).   This was the explicit aim, foreshadowed a recent paper by the Federal Reserve Bank of New York (http://www.ny.frb.org/research/EPR/08v14n2/0809keis.pdf).  The Fed is now free to expand bank reserves almost without limit while maintaining the fed funds target (at least very loosely).

(2)  The Fed’s focus has now shifted from easing the interest rate to increasing the quantity of money, and the aim of supplying funds is no longer to ease concerns about narrow liquidity but to increase the overall money supply, thereby easing concern about the stability of the banks, while hoping to engineer an eventual upturn in lending, activity and (whisper it quietly) inflation.

This is precisely the radical strategy adopted by the Bank of Japan in the late 1990s and early part of the current decade, when it was described as “quantitative easing”.  Fed Chairman Ben Bernanke, a keen student of liquidity traps during the Great Depression and Japan’s decade long banking and economic slump, threatened some time ago that the Fed could always increase the quantity of money by manipulating the size and composition of its balance sheet.

In a 2004 paper Bernanke noted: “nothing prevents a central bank from switching its focus from the price of reserves to the quantity or growth of reserves. When stated in terms of quantities, it becomes apparent that even if the price of reserves (the federal funds rate) becomes pinned at zero, the central bank can still expand the quantity of reserves. That is, reserves can be increased beyond the level required to hold the overnight rate at zero–a policy sometimes referred to as ‘quantitative easing.’ Some evidence exists that quantitative easing can stimulate the economy even when interest rates are near zero; see, for example, Christina Romer’s (1992) discussion of the effects of increases in the money supply during the Great Depression in the United States.”

Bernanke argues that quantitative easing may affect the economy through at least three channels:

(1)  Large increases in the money supply will lead investors to rebalance portfolios, reducing yields on other non-money assets, stimulating investment,consumption and other economic activity.

(2)  Setting a high level of reserves and committing to maintain it until certain (economic) conditions have been fulfilled is an alternative and perhaps more visible and credible way to stimulate growth and promising to maintain a low interest rate.

(3)  By expanding its balance sheet and replacing public holdings of interest-bearing government debt with non-interest bearing (or very low interest) money and reserves, the central bank may attempt to hold down yields on a range of government securities, making borrowing cheaper, and cutting the costs of an expansionary fiscal policy. The strategy works if and only if the central bank can pre-commit not to reverse the quantitative easing policy for some considerable period and until certain conditions have been met.

Bernanke went on to note: “The forms of monetary stimulus described above can be used once the overnight rate has already been driven to zero or as a way of driving the overnight rate to zero.
However, a central bank might choose to rely on these alternative policies while maintaining the overnight rate somewhat above zero.”

Moreover, alternative monetary policies such as quantitative easing could enable the central bank to avoid the problem that nominal interest rates cannot readily be cut below zero:   “A quite different argument for engaging in alternative monetary policies before lowering the overnight rate all the way to zero is that the public might interpret a zero instrument rate as evidence that the central bank has “run out of ammunition.”

That is, low rates risk fostering the misimpression that monetary policy is ineffective. As we have stressed, that would indeed be a misimpression, as the central bank has means of providing monetary stimulus other than the conventional measure of lowering the overnight nominal interest rate”.   Since the middle of October, the Federal Reserve has begun to put precisely this strategy into practice.

Quantitative easing has begun.

Bernanke once threatened to send in the monetary helicopters if that was necessary to avoid deflation and a renewed Great Depression. The massive surge in bank reserves in the past fortnight suggests the helicopters have now been scrambled and the strategy is being put to the test.


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They will replace a deflationary depression with an inflationary depression. If I was out of work I would rather have prices going down. If they are “successful” the next down turn will be harder. With our current political and monetary system there is no way the real economy can escape a down turn with a normal market correction. The Fed and the government created the problem with easy money and loose lending. Can they escape doing the same thing?

Posted by david moore | Report as abusive

Whatever. Theory is theory and practice is practice. Greenspan, with his blind belief in Ayn Randian nonsense, created this crisis. Bernanke, with his academic theoretical nonsense, is going to drive this down much farther.

I ask two basic questions: (1) Who would the banks lend to? and (2) What will be the money used for, i.e., to what productive means?

If we can’t answer these two questions, no amount money would ease the problem. On the other hand, it may lead to hyperinflation and treasury might need to print new $100 Billion dollar currency notes like Zimbabwe.

Posted by JC | Report as abusive

Quantitive Easying is a term that distorts the truth.
Inflation = Money Supply. The higher the inflation, the less our money is worth.

How in the world, can we solve the problems of inflation (the increase in the supply of money) with more inflation? The “Fed” wants to print more money, because more money means more loans. More loans means more interest. More interest causes us to borrower more money to repay the existing loans. It is a game of monopoly and we(tax payers) are losing! Under the Federal Reserve System, perpetual debt is garunteed! Give the issuing power back to congress where it rightfully belongs!

How about letting the wildly inflated asset prices correct to historical levels of affordability before we prime the pump? Along the way, let the banks with good business models take the place of those with bad.

Bernanke spent his entire life studying books on how to prevent deflation. He lived in a splendid fantasy land and was validated beyond belief for his efforts. But when it came to real life, he proved that he hasn’t a clue on how to prevent deflation.

Internet bloggers without a formal education in economics had been screaming for years that we were headed for a massive housing correction accompanied by economic contraction. Meanwhile, Bernanke was confidently stating we didn’t have anything to be concerned about. Now that it’s too late to provide any real preventative measures, Bernanke is treating the symptoms instead of the cause. But the rat sheep just close their eyes and say, “he’s an expert, let him be.” IMO, to be an expert on something, you have to have “real life” experience. Reading books and writing papers reciting historical events is meaningless when it comes to acting in the real world. Einstein correctly pointed out that “imagination is more important than knowledge.”

Bernanke has a great deal of knowledge, and very little imagination. So what good is he?

Several commentators below make the over-simple assumption that printing money necessarily results in inflation. First, the evidence: Japan engaged in quantitative easing with printed money, and big time. Result? Practically nothing. No effect on inflation and no effect on anything else. Second, the theory.

One theoretical reason why Q.E. has little effect is that securities are viewed by their owners as savings (i.e. stuff they have no intention of spending). If government induces savers to convert part of their savings from securities to cash, the cash will not get spent: it will get dumped in a deposit account. Indeed, a proportion of Japanese security owners ran out and bought foreign securities when their own (Japanese) securities were converted to cash.

Q.E. seems justifiable if its purpose is to relieve banks of enough of their toxic assets to prevent a banking collapse. As to using Q.E. to drive down long term interest rates, this seems questionable. We all know that if governments’ attempts to rectify the recession result in excess inflation in two years time, governments will take a variety of deflationary measures, like RAISING interest rates. If I were offered a variable rate mortgage starting at around 0%, I wouldn’t run out and buy a mansion. And if I were a banker, I wouldn’t offer anyone a loan for 10 years at 0%.

I’m confused.

The whole issue of quantitative easing appears to be nothing other than inflating the money supply as well as manipulating the manner in which finanancial/monetary accounting is presented by the Feds and the Central Banking system . . . all for the sake of putting Humpty Dumpty (the former US economic lifestyle)
back together again; the way it was before deleveraging appeared within the global economy.

Observation and commentaries reflect quantitative easing in Japan did not jubilantly yield the desired outcome. But it could be argued the strategy did work in the manner it was designed . . . resulting in the large economic component of Japanese end users, the masses, continuing their customary frugal way of life . . . being ‘savers’, not spenders.

Understandably, the anxious, opinionated jury is not even close in accurately determining whether quantitative easing will provide a desirable end result in the US because the strategy is just beginning to being implemented. But the projected outcome could be successful – assuming, of course, the desired outcome is having the abundant supply of newly created monies being efficiently and effectively channeled to the large economic component of American end users, the masses, going back to their habitual lifestyle of spending for immediate gratification and committing to long term debt with a fair number of bankruptcy filings.

What a huge bet our financial power players are making by implementing such a game plan strategy; for not only is the outcome dependent upon the path of newly printed money, from beginning to end, they (the financial power players) will be hampered to affectively control the end result of implementing quantitative easing due to the inevitable, usually counterproductive wild card being injected along the way by the unmeasureable participation of the political class..

Maybe I’m not so confused after all . . . not only is change inevitable, life IS a gamble.

Posted by rbblum | Report as abusive

If my memory serves me correctly the words ‘resort to’ and ‘printing money’ have an historic liaison somewhere in thirties Germany.

Posted by John Peasnall | Report as abusive

So let me get this straight…using credit card to pay up another credit card is insanity, but borrowing more money to pay up for the excess of printed money which caused inflation is an asnwer? I am so confused that i don’t even know where to go to clear my mind anymore. The fed, the central banks, and all its staff members are already free people because they have the power to decide to make money out of nothing, but we don’t? I think that’s a double standard. It’s like, canadian or american soldiers can go to war and kill innocent people and not be condemned for it, but if they kill an innocent person or a lying devious politician, banker, economist one gets the maximum sentence, lmfao!!! This is just hilarious

Posted by lucivaldo | Report as abusive

How far are the FED prepared to go with the value of the Dollar? Have they any contingency plan if there is a sale on the Dollar? What do they determine to be long enough at this ploy and how long will the pullback period be. Are they going to indicate when this will start? They have to outline the precautions.

Posted by Donal Jackson | Report as abusive

Quantitative easing whereby newly printed notes are handed over to banks in the expectation that bank lending will be revived does nothing to solve the main problem of banking namely defaulting borrowers. The fiscal solution to defaulting borrowers involves giving an annual $1500 housing benefit to all United States citizens in reduction of their toxic bank overdrafts where appropriate, these toxic debts will then cease to be toxic.

Posted by Peter L. Griffiths | Report as abusive