Question from Rick Cosier
Warren, thank you for attempting to explain QE, but I don’t really understand it. Perhaps you can enlighten me a bit more.
You mention that the Fed is selling bonds to the market. Who exactly is ‘the market’, when do the bonds mature and what interest rates are involved? When the Fed purchases longer dated bonds later, who do they buy them from and at what price? The impression is that the Fed is supplying money to ‘the market’ for next to nothing, and ‘the market’ invests the money back into US bonds thereby making a tidy arbitrage with absolutely no risk. Consequently, very little of the money is actually being lent to bone fide ‘real world’ investors, which is doing nothing to stimulate the economy.
Furthermore, US debt levels total trillions of dollars which equates to a stratospheric percentage of GDP never before seen. Can you tell me how the central banks expect to repay this debt? Is there a plan, or are they just hoping everything will turn out all right?
Reply from Warren Bird
“The market” is anyone who owns Treasury bonds or the other assets that the Fed purchases. The Fed deals directly with a group of banks, but those banks could be selling to the Fed bonds they own themselves, or broking a sale on behalf of their clients who are happy to sell from their holdings.
(This is similar to when a fund manager wants to buy bonds for their portfolio. They go to a bank to do a deal; that bank might sell from their own inventory or they might go to other counterparties to get them. The process of having intermediaries such as the banks is what brings all the different buyers and sellers of securities together so that transactions can take place.)
The bonds that the Fed has been purchasing have a variety of maturity dates and have been transacted at many different yields. Over the time the Fed has been doing QE, US bond yields have traded between around 1.4% and 3%. Every month the Fed has bought the amount it wanted to at whatever yield was trading in the market at the time. For a period in 2011 they also changed the maturity of their holdings by going to the market to sell bonds maturing in less than 3 years and buying bonds with maturities from 6 to 30 years. (This was known as Operation Twist.)
The Fed is not supplying money to the market for next to nothing. It’s a commercial transaction. The market has bought bonds from the US Treasury and then sold them to the Fed at the current yield, which is based on all the other billions and billions of transactions in bonds and other interest rate securities every day. Sometimes the holders will have made a short term gain, sometimes they will have made a short term loss. In all cases they have given up an asset yielding well above the interest rate they are earning on the cash that they get paid. The point of QE is to get cash into the banks that they can then lend to consumers and businesses.
The idea that the money isn’t getting out to ‘real world’ investors crops up a lot. One thing to understand is that monetary policy – whether it’s the ‘normal’ policy of changing the cash rate like the RBA is still doing, or QE – only ever is a method of persuasion, not coercion. The RBA cuts the cash and hopes/expects that this will result in more borrowing for real economic activity. But if the economy is weak and confidence low, that mightn’t be enough and they have to cut again. The judgment the RBA Board makes every month is whether the current level of the cash rate is producing the macroeconomic outcomes they want. If it is, then they say that the current setting is “appropriate”. If it isn’t, then they change the cash rate.
QE operates when a zero cash rate is proving to be insufficient to generate stronger economic activity. The central banks try to encourage more credit creation by outright bond purchases. But they aren’t there to pick the loans to be made, or to force anyone to borrow if they don’t want to. They make the liquidity available, try to make yields on longer term borrowing as cheap as possible, and let the real world participants make the ultimate decisions.
In my view it has worked. The Bank of England has estimated that UK economic growth is about 1.5% stronger than it would have been without its QE program. I think the US housing market wouldn’t have recovered as strongly as it has without the Fed buying all those mortgage-backed securities, so the US economy has benefited.
It’s true that a lot of the cash that the banks have received from their bond sales to the Fed is just sitting in reserves and hasn’t been loaned out. That’s not necessarily because the banks won’t lend, it’s because the economy has been deleveraging and borrowers have been reducing their gearing. As I said, monetary policy is only ever able to provide an environment conducive to credit creation, but they can’t force the issue.
The Fed has this morning announced a modest tapering of QE, back to $75 billion a month. They’ve done this because they see signs that the US economy has begun to improve on a more sustainable basis, so it doesn’t need quite as much stimulus. Personally I don’t believe that this improvement would have happened without QE, so I think it’s working. It hasn’t worked as fast as everyone would have liked, but that isn’t the fault of QE. It is simply a reflection of how bad the underlying economic fundamentals have been and how steep the hill has been up which QE has been pushing. We all hope that the top of the mountain is being reached and that the world can get through this disaster that the GFC has been. But we wouldn’t be as close to that point if central banks hadn’t run easy monetary policy.
The one thing we do know is that there is now a lot of liquidity that can be put to work when real world agents have investment projects and new businesses to create, and the confidence to borrow to fund them. That is when the money supply will really grow and the Fed will have to be on its toes to reduce the stimulus at the right rate so it doesn’t just turn into inflation. It will be a good problem to have, I think.
On your final point, the central banks don’t have to repay the debt – the Government does. The central banks have chosen not to merely “print money” because to do so would take away from Governments the discipline of having debt on their books that they have to pay back. As I said in the article the conduct of QE is independent of the size of the budget deficit or the government’s total debt level.
Of course, the Fed and other central banks will believe that their governments have a plan to reduce debt levels over time. QE is part of the plan because the best way for governments to get debt down is go support economic growth, which generates the taxes they need in the future to pay their debts. But that is taking us into another huge topic, beyond the scope of this piece.