As you are surely aware by now, the US Federal Reserve has announced a new round of quantitative easing which like the ECB’s outright monetary transactions (OMT) is a new program of large scale asset purchases by a central bank. I thought I’d spend a bit of time today talking about these programs because once again I have noticed some large misconceptions in the media about what these operations are, and more importantly, what the likely outcome of them is.
As I have stated before, one of the major issues I have with the reporting of these types of programs is that they are referred to as “money printing” which, although at some level is technically correct, provides a fairly deceptive view of what is actually happening and in many cases simply adds to the confusion as to what is actually going on.
The reason these operations are referred to as money printing is because when a central bank makes purchases of financial assets it does so by adding amounts to the reserve accounts of banks that either 1) own the asset or 2 ) are the registered bank of the holder of that asset. In the case of 2 ) the bank will also create a deposit for the account holder. The difference here is quite important so I’ll come back to this point later.
It should be noted, however, that the creation of new reserves is not unique to QE, in fact all reserve banks create, and destroy, reserves on a daily basis in order to maintain the interbank market rate. See here for more in this topic. The purchase and sale of securities adds or drains reserves available in the banking system which controls the short term interest rates banks charge each other to borrow funds. This is the basic process in which central banks set interest rates.
Unorthodox monetary policy tends to be larger and sustained purchases of a particular types of financial asset in order to a) supply interbank liquidity to ensure monetary policy transmission, b) reduce systemic risk and/or c) reduce longer term interest rates. The ECB’s OMT probably covers the first two, QE3 the third.
In the case of QE3, Ben Bernanke has stated that the Fed will purchase US$40bn/month of mortgage backed securities. By doing so the amount of securities held by the private sector will reduce which bids up the price and in turn lowers the yield. As MBS are used as a benchmark for mortgage rates this purchases is expected to bring down the long term interest rate paid by US citizens on their home loans.
In the case of OMT, Mario Draghi’s plan is for the ECB to purchase sovereign debt of certain Eurozone nations again to bring down the yield. The difference being that OMT is more about financial stability and monetary policy transmission. But in both cases the basic idea is that the reserve bank will purchase securities in the market and by doing so will drive down interest rates. For QE3 the target securities are MBS , for the ECB’s OMT it is periphery government bonds.
Now for the catches.
There are obviously side effects of these programs, these aren’t my major focus today so I’ll skip over them but it should be noted that these operations lower the respective currency relative to other currencies and tend to lift equity and commodity prices in the short term as the additional liquidity finds a new home. The overall outcome of these side effects is inflationary pressures in food and energy that potentially decrease consumption and therefore reduce overall economic activity.
What you may have also noticed about these programs is that it is possible that there is no overall direct effect on the public. Unless a household or business themselves happen to be a holder of a particular type of financial asset then the public doesn’t actually receive any of this money. As I stated above, in the case where a bank is the owner of an asset all that occurs is an asset swap which creates excess reserves in the banking system. That is, in either case the major outcome of these policies is simply a change in composition of the asset side of commercial bank’s balance sheets.
For households and businesses the real outcome is potentially interest rates are lower than they otherwise would be, as Ben Bernanke stated:
Our mortgage-backed securities purchases ought to drive down mortgage rates and put downward pressure on mortgage rates and create more demand for homes and more refinancing.
So basically these operations are all about trying to get households and non-financial corporations to borrow more money through commercial banks and spend their savings in the economy. That is, these programs are aimed at increasing the velocity of money which includes both an increase in private sector debt and a lowering of deposit based savings. None of this is about giving money away as suggested by the term “money printing”.
Notice the term “ought to” in Mr Bernanke’s statement. It’s important because whether or not this actually occurs is dependent on two things. Firstly, the decision of the banks as to whether they will pass on lower rates to consumers and expand their loan books, and secondly, how exactly the private sector will act in the face of lower rates in terms of new loans and savings.
These two points play a major part in what we are seeing in Europe and why ECB’s balance sheet expansion is failing there. In places like Spain the retrenchment of the private sector after an an asset shock is being made worse be the attempted de-leveraging of the government sector, as I said:
So with the external sector in this state and the private sector unable and/or unwilling to take on additional debt as it attempt to mend its balance sheet after an ‘asset shock’, the only sector left to provide for the short fall in national income is the government sector. If it fails to do so then the economy will continue to shrink until a new balance is found between the sectors at some lower national income, and therefore GDP.
The inability and/or lack of desire for new credit is by the private sector is the tell-tale signs of a balance sheet recession which has the following attributes
- A balance sheet recession emerges after the bursting of a nationwide asset price bubble that leaves a large number of private-sector balance sheets with more liabilities than assets.
- In order to repair their balance sheets, private sector moves away from profit maximization to debt minimization.
- With the private sector de-leveraging, even at zero interest rates, newly generated savings and debt repayments enter the banking system but cannot leave the system due to the lack of borrowers.
- The sum of savings and debt repayments end up becoming the leakage to the income stream.
- The deflationary gap created by the above leakage will continue to push the economy toward a contractionary equilibrium until the private sector is too impoverished to save any money.
- In this type of recession, the economy will not enter self-sustaining growth until private sector balance sheets are repaired.
So QE and OMT are monetary programs that, in part, aim at increasing the leverage of the private sector, but they have only attempted to address the supply side of the equation. Fiscal policy in the EZ is continuing to lower the private sector wealth and by doing so is reducing the demand for credit which in turn is further weakening the economy. This dynamic appears to be more that offsetting the expansionary monetary program which is why you have seen the ECB’s response continue to become larger and larger over time. The Eurozone is therefore likely to continue to see poor economic outcomes even under the open-ended OMT because the insistence on the fiscal compact as a pre-cursor to renewed intervention is likely to be completely counter-productive.
I think the jury is still out on whether the US is seeing expansion in the real economic activity, but there is no doubt it is performing better than the Eurozone. Whether that continues has a lot to do with what happens in regard to the “fiscal cliff”, which is their own version of the fiscal compact.