Thursday, April 28, 2011

Quantitative Easing: The most important ineffective strategy ever!

Quantitative Easing has become the new “hot term” for a policy that in reality does pretty much next to nothing.

Quantitative easing is the term used when the central bank has already lowered its target rate (Fed funds) to zero and can go no lower. So to act like it’s still doing something, it buys securities somewhere else along the term structure and continues adding to bank reserves. In QE2 the Fed targeted government bond yields and bought Treasuries. In QE1 the Fed targeted mortgage rates and bought mortgage backed securities.

When the Fed buys Treasuries it’s as if the Government never sold them in the first place. It is removing that supply of Treasuries that was first put there by government debt sales. And remember, Treasuries comprise part of the financial assets held by the public, so you’re basically taking those assets away.

Here’s what happens…

The public gets stripped of one asset—a Treasury—and loses the 3.5% interest payment (I’m using the 10-year) and gets another asset—a reserve balance—with a 0.25% interest payment.

The public has just lost 325 basis points of interest income!!! Some deal!!!!

Yet people view this as being wildly inflationary and stimulative. You can clearly see, it’s not. In fact, one could argue that the loss of interest income is really deflationary, particularly when so many people remain unemployed.

So why does the market rally on this and commodities go crazy?

Good question. I really don’t know. Probably a belief that QE does a lot more than it does.

But if that’s what it takes to move the market, it’s good enough. The Fed may know this and is manipulating expectations. The Fed is big on “expectations theory.”


Mario said...

yes. You make it all so clear Mike. Thank you.

I think the reason why those rallies are happening is because QE2 allows for greater portfolio management and asset re-allocation. They're no longer in bonds, so where do they park their money? They don't just hold it in reserves...they dump it in stocks and comms...the Fed wanted this to happen b/c as you say they are big on expectations and these rallies they were hoping, as what seems like a last ditch effort, to get people to feel wealthy.

QE2 may also have been a bad attempt at keep mortgage rates low too.

Tom Hickey said...

I think that this could also be considered something of a test case for what would happen if the US went to no bonds as some MMT'ers suggest. This would argue that consumer inflation is not a problem, but there other financial assets would be priced higher.

Of course, this is not really a test case because we are in a special situation at present, with lagging demand and no incentive to borrow or invest. In a more normal situation, how much could be expected to flow to real investment instead of financial. The jury is still out on this. However, a tax policy favoring real investment over financial could also influence this.