Thursday, March 8, 2012
The Fed's "new and improved" QE
There was a story in the WSJ yesterday about how the Fed is considering a new form of “sterilized QE” if it decides to do QE again. I’ll explain what this is in a minute, but first, the reason they are considering this new QE is because, while they admit internally that regular QE DOES NOT CAUSE INFLATION (as MMT proponents have been saying), they are worried about the public’s perception that it does. As an aside, why doesn't the Fed just come out and explain to the public how QE actually works, and allay those fears, instead of spending all this time and energy to devise some new machination of QE to pretend they are taking care of a non-problem? That would be too easy, I guess. (I could explain it to the public if they asked me to, but I’m not holding my breath.)
Anyway here’s a little review on how the “regular, plain vanilla” QE works. The Fed buys securities from the public (Treasury bonds or notes, for example) and that adds to reserves in the banking system. The action of buying those securities removes one asset—the bond—and replaces it with another—the reserve (cash)—balance. NO NEW MONEY HAS BEEN CREATED. Or more precisely, no new financial assets have been created. The public has the same nominal dollar amount of financial assets as before QE, the only change being the composition of those assets (less bonds, more reserves). The duration has become shorter. In other words, they have less bonds (which have some duration) and more cash (which has zero duration). AND (this is a big point), interest income has been removed.
As the Fed correctly understands, this is not inflationary. However, for some reason they just can’t explain it in the simple fashion that I have done here???? Weird.
Okay, so here’s how the “new and improved” QE is going to operate.
The Fed will buy bonds and credit the system with reserves, just like before. But then, it will sell shorter-dated maturities out of its portfolio and take back those reserves. Yep, you read that right…it will add reserves then take them back. Whoopeeee!!! This is what our genius financial leaders are going to do. Can you believe this?? And by the way...just how does this boost the economy?
The only effect on the economy is that it will lead to a flattening of the yield curve: long term rates come down (due to Fed buying) relative to short term rates (where the Fed is selling).
End result: it will likely hurt banks and financial firms, who actively “arb” the yield curve. Nice job, Fed.
BTW: I emailed Jon Hilsenrath, the WSJ reporter who wrote the story, simply to point out that he needn't refer repeatedly to "money printing" whenever he talked about QE, as he did in his article. I haven't heard back.