What is Quantitative Easing?

What is Quantitative Easing?

It's basically when a central bank can't cut interest rates anymore, because they are too low. It can also happen if a central bank decides that cutting rates won't work for some reason. To meet its liquidity objectives, the central bank instead manipulates the size of its balance sheet.

How does it normally work?

The central bank buys financial assets from financial institutions using money it creates out of thin air. This causes bank reserves in the financial system to increase, creating 'excess reserves'. The result is a huge increase of the monetary base in the economy.

It's called quantitative easing because it 'involves a change in the quantity variable (reserves and/or the monetary base) as opposed to a change in the interest rate target.'

What's the point?

It's meant to provide needed liquidity to a financial system and stimulate economic activity, though it carries inflation risk.

But... then what is 'sterilization' and how does it control things?

Sterilization is used to offset the acquisition of assets by a central bank. After the central bank buys new assets, it can 'sterilize' these assets by either getting rid of different assets or adding an equal, counterbalancing amount of liabilities. It is important to understand that 'when the acquisition of an asset is sterilized, there is no QE because the balance sheet effects are neutralized.' Thus, when sterilization is happening, quantitative easing hasn't happened yet, even though the central bank is buying financial assets from the market as a form of support.

When did QE in America start?

'The Federal Reserve shifted to quantitative easing in September 2008 when it expanded a number of liquidity programmes, including the term auction facility (TAF) and central bank FX swap lines, and ceased its sterilization efforts.”

QE started in September 2008, when sterilization ended but the central bank was still buying financial assets from financial institutions.

'Up to this point, the Fed had been sterilizing the impact of its new support facilities by liquidating Treasuries.

Liquidating Treasuries

For example, the TAF was introduced in late 2007 and was scaled up to US$150 billion by May 2008. Over that same interval, the Fed liquidated more than US$200 billion of its holdings of Treasuries in order to sterilize the TAF and other special programmes.

So, the volume of bank reserves was essentially unchanged during this period, but the mix of balance sheet items shifted.'

QE caused bank reserves to explode.

In September 2008 – as financial markets were melting down – the Fed cried uncle and gave up trying to sterilize. Excess reserves rose from a normal level of US$1.0-1.5 billion to US$270 billion in October 2008 as the liquidity support programmes continued to expand.

These reserves were created from central bank money created out of thin air. This was the 'money-printing' so many have complained about.

By the end of 2008, excess reserves reached US$800 billion and the monetary base had nearly doubled in size.

In early 2009, the Fed started to purchase large quantities of MBS and agency debt, and in March it began buying Treasuries. However, it’s important to note that the bulk of the QE took place several months before the Fed started buying mortgages and Treasuries.

Thus, it is incorrect to simply refer to the Fed’s bond purchases as QE.

The Fed’s objective was to restore liquidity to important markets, and it did.

The Fed succeeded in achieving these goals. The TAF, FX swap lines and alphabet soup of other liquidity support facilities appeared to play an important role in reining in LIBOR.

The economy was jump-started, and pressure was taken off of housing, by far cheaper mortgage rates.

Meanwhile, the LSAPs (large-scale asset purchases) helped to drive mortgage rates lower. This provided a significant amount of stimulus to the economy.

Many were worried about the effects of giant growth in money supply... but here's why it has been okay so far.

As mentioned earlier, the monetarist view is that QE represents an important event because the expansion of the monetary base is likely to be accompanied by growth in the money supply. However, this was not really the case in the US. While the base doubled, growth in narrow money experienced only a modest acceleration, as the money multiplier plummeted. This reflected the fact that the excess reserves created by the Fed were parked in cash.

Banks have been paid interest on their reserves to prevent inflation.

The Fed has been paying interest on banks' reserves in order to incentivize them not too lend everything out, and thus in an attempt to prevent huge excess bank reserves from translating into inflationary forces. This interest is likely higher than the market-rate which would banks would get if such a program didn't exist. It's meant to put a floor under short-term rates (i.e. rates can't fall below Fed's interest rates on the reserves.)

This entire process could prove itself to have been extremely smart.

If the Fed can now engineer a successful exit from QE, any inflation consequences and market distortions should largely evaporate.

It all depends on whether the Fed can restore normalcy to its balance sheet successfully.

The Fed plans to use multiple methods in order to reduce the size of its balance sheet and remove excess reserves from the banking system. For our purposes here, the exact methods need only be briefly referenced: 'The Fed plans to use term deposits, reverse RPs and asset sales to unwind QE. The asset sale option has generated a lot of interest recently and appears to have gained unanimous acceptance among Fed officials.

But the sequencing still appears to be reverse RPs and term deposits first, followed by asset sales later on.

It'll be a tricky balancing act for the U.S. going forward...

The trick will be whether the Fed can use the aforementioned methods to drain at least one trillion dollars of excess reserves from the banking system, as a completion of the QE process, in a balancing act between unsettling the financial system and high U.S. inflation.

'We are... concerned that the Fed may not be able to hike the fed funds rate when the time comes, unless it is willing to drain away a size able portion of the excess reserve position.

...

Bernanke is saying that the Fed will try to engineer a gradual exit from QE, but could be forced into a more rapid exit. It should be obvious that the process of draining US$1 trillion or more of excess reserves in a short period of time is fraught with potential market risks.

A rapid exit, in a bid to prevent emerging inflation, could cause a substantial shock to the financial system, as it would be a very sudden form of monetary tightening.

It's perilous, and now Europe is beginning a similar journey, just as the U.S. is exiting.

Last week, the ECB announced that it would start to intervene in euro area bond markets and buy public and private debt under a new Securities Market Programme (SMP)

...

The ECB’s recent decision to purchase debt securities in order to ease market ‘dysfunction’ has certainly had the desired impact on bond yields, but it has also left many questions unanswered. Do the bond purchases represent QE or a move towards QE?'

What is Debt Monetization? How does it work?

1. Suppose the government runs a deficit... E.g. let government spending on goods and services be $10,000. For simplicity, all transactions are in cash. Let net taxes from all sources be $9,000 so there is a $1,000 deficit.

2. The government has $9,000 in cash from taxes, but needs to spend $10,000. Somehow (print money, borrow money, raise taxes, or lower spending) it must get $1,000 more.

3. Suppose it decides to borrow – issue new debt. Then the Treasury sells a government bond to someone in the private sector for $1,000. The person gives $1,000 in cash to the government and in return gets an IOU (perhaps for, say, $1,100 in one year).

4. The government now has $9,000 in cash from taxes and $1,000 it has borrowed from the public so it can now purchase $10,000 in goods and services.

5. Now let’s do the monetization step. This can happen automatically, as explained below, but for now let’s have the Fed conduct a $1,000 open market operation to increase the money supply. To do this, it cranks up the press, loads in some paper and green ink, and prints a brand new $1,000 bill. It takes the $1,000 bill and purchases a bond from the public, for simplicity make it the same bond the Treasury just issued. Then the money supply goes up by $1,000 (and may go up more through multiple deposit expansion) and government debt in the hands of the public goes down by $1,000 since the Fed now holds the bond. The increase in the money supply is inflationary.

6. What has happened? When all paper has ceased changing hands, the $10,000 in goods and services is paid for by the collection $9,000 in taxes and by printing $1,000 in new currency. The government debt simply moves from the Treasury to the Fed (in the U.S., the Fed pays for its operations from its earnings on these bonds and remits the remainder to the Treasury; I believe the remittance is weekly, but I’m not positive on that). (In other words, the Treasury just ends up owing money to the Fed.)

How can constant interest rate rules potentially cause debt monetization to occur automatically?

Suppose the Fed follows a constant interest rate rule. Further suppose an increase in government spending increases the interest rate (see here for a paper on this by Benjamin Friedman posted at the NBER site today). That is, when the government issues new debt, the supply of bonds increases lowering the price and raising the interest rate. Under these assumptions what will happen when there is deficit spending?

1. Deficit spending financed by borrowing from the private sector causes the interest rate to go up. Thus, initially two things happen, bonds held by the public (debt) increase and interest rate increases as well.

2. But the Fed is following a constant interest rate rule. Seeing the interest rate rising, what should it do? It should increase the money supply and to do so it prints money, as above, and uses it to buy bonds from the public. In order to return the interest rate to where it started, all of the debt issued in step one must be purchased with newly printed money (can you smell the fresh ink?).

3. In the end, what happens? It’s just as above, the entire deficit is financed by printing money and the debt issued by the Treasury ends up in the hands of the Fed

Monetization vs Sterilization

Sterilization is usually discussed in the context of currency intervention, but it’s functionally the same when a central bank wants to drain cash from the system.

It’s the process of selling longer-dated assets in exchange for zero-maturity money. This locks money up for a time, effectively removing it from current circulation. Usually, this would be done by selling off some of the Treasuries on the Fed’s own books for cash. The Fed will take the cash it receives and sit on it.

If the Fed doesn’t own enough treasuries, it might not be able to do this in large enough scale on its own. Now, the Treasury could just issue more treasuries and sell them to the Fed.

But the new ability to pay arbitrary interest rates to banks on their deposits is quite similar and can be used for sterilization. The banks deposit their cash with the Fed, which locks it up, taking it out of circulation.

The big difference is maturity: these deposits are generally just overnight, while a Treasury has a much longer term, up to 30 years, but with whatever maturity the government wants. Perhaps the Fed could start offering CD’s, essentially, to remove even this distinction...

The Federal Funds Rate

The Fed maintains the federal funds rate - the interest rate at which US banks make overnight loans to each other - at (or close to) the Fed's chose target by injecting (the rate falls) and extracting (the rate rises) liquidity from the banking system. The Fed does this through repurchase agreements (repos) or by manipulating the stock of Treasuries on its balance sheet.

However, when the Fed wants to keep the federal funds rate unchanged but add liquidity by other means (perhaps by auctioning off funds), the Fed sterilizes the effects of the new liquidity on the monetary base by performing an offsetting open market operation - an overnight repo or selling Treasuries outright.

Leaving money in the banking system as excess reserves increases the supply of federal funds & reduces the federal funds rates (below the Fed's target). The increased money supply is inflationary-too much money chasing the same number of goods & services.

Treasury Auctions

primary dealers - large securities dealers/financial institutions that are active in buying & selling US government securities & have established business relationships with the NY Fed

* The US Government auctions Treasury bills & notes to finance the public debt.

* Most are bought by primary dealers; A small amount are bought by individual investors (who buy them directly from the Treasury Dept @ auction)

* Currently... bills in three- & six-month maturities; notes in two-, five-, and ten-year maturities;

* Occasionally, Treasury auctions cash management bills (CMBs) (w/maturities that are set on an issue-by-issue basis) to meet short-term financial needs

Bidding

* Bids are accepted up to 30 days in advance of the auction, & may be submitted electronically through the Treasury Automated Auction Processing System (TAAPS) and by mail. All bids are confidential & kept sealed until auction date.

* Two types of bids may be submitted...

(1) Non-competitive tenders... generally submitted by small investors & individuals... guaranteed to receive securities... amount of securities that may be sold to single non-competitive bidder is limited to $1MM per auction for bills & $5MM for coupon issues

(2) Competitive bids... usually submitted by primary dealers for own accounts, or on behalf of customers... bids are submitted in terms of yield or discount rate... to ensure that 2ndary market for Treasury securities remains competitive, bidders are restricted to receiving no more than 35% of total amount of securities available to public

* Three categories of bidders; Dealers + Directs + Indirects = 100%

(1) Dealers submit bidding for their own house accounts & are required to make bids

(2) Directs are non-primary dealer submitters. They may make bids for their own books or on behalf of clients. Some direct bidders may make bids to look to eventually become primary dealers.

(3) Indirects are customers placing competitive bids through a primary dealer, and are largely foreign and international monetary authorities placing bids through the NY Federal Reserve Bank

Determining the winning bids

* The non-competitive tenders (which automatically receive securities) are subtracted from the total offering to determine amount awarded to competitive bidders

* The Treasury works down the list off competitive bidders, accepting highest bid prices until all securities have been awarded... all lower competitive bids are rejected

* Single-price auction... successful competitive bidders & noncompetitive bidders buy securities at price that equals the highest accepted yield or highest accepted discount rate (i.e. lowest bid)

* Total amount of bids received & total accepted are made available to the public.

* The high, low, & weighted averages of the price, discount rate, and equivalent bond yield of the accepted competitive bids are released to the public

* The weighted average price & yield from the successful competitive bids are applied to the non-competitive tenders

Treasury auctions tail

* In bond market jargon the tail is the distance from the level at which bonds were trading on a when issued basis immediately prior to the auction, to where the Treasury was able to complete the sale. A long tail represents a lack of interest from clients and dealers who would normally underwrite the security.

* It's the spread in price between the lowest competitive bid accepted by the U.S. Treasury for bills, bonds, and notes and the average bid by all those offering to buy such Treasury securities.