Quantitative easing (QE) is what happens when governments can’t cut interest rates much lower.
It’s the kitchen sink of easy money from the government.
While the U.S. and UK have been neck-deep in QE for awhile already, now Europe’s joining the action in order to save its financial system.
QE is an extremely radical act of support for markets that involves a tight balancing act between stimulating your financial system and preventing hyperinflation.
None of the guilty parties above have yet to cross the chasm. Europe’s just begun the process.
(Partly sourced via Morgan Stanley’s ‘ABC’s of QE’ by David Greenlaw)
What is ‘Quantitative Easing’?
Image: AP
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.’
Source: Morgan Stanley
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.
Source: Morgan Stanley
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 (see Exhibit 5), 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.
Source: Morgan Stanley
See the huge jump below? That’s when sterilization ended and QE began.
‘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 (see Exhibit 6).
So, the volume of bank reserves was essentially unchanged during this period, but the mix of balance sheet items shifted.’
Source: Morgan Stanley
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 (see Exhibit 7).’
Source: Morgan Stanley
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.’
Source: Morgan Stanley
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 (see Exhibit 8).’
Source: Morgan Stanley
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.
Source: Morgan Stanley
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.’
Source: Morgan Stanley
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.
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.’
Source: Morgan Stanley
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.’
Source: Morgan Stanley
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.’
Source Morgan Stanley
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?’
Source: Morgan Stanley
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