America is a land of contention, and one of the most contentious topics here (I’m in Seattle as I write) is the impact of the Federal Reserve’s policy of “Quantitative Easing” – otherwise known as ‘QE’. The Federal Reserve has committed to spending $85 billion every month buying a wide range of bonds from banks, until such time as the US unemployment rate falls below 6.5 per cent.
The Fed has implemented this policy because it believes it is the best way to stimulate demand in a depressed economy. Its critics oppose it because they believe this massive amount of ‘money printing’ must inevitably lead to ruinous inflation.
I reckon they’re both wrong, and in a seriously wonky post I’ll try to explain why, using my modelling program Minsky.
Minsky develops a model of monetary flows using double-entry bookkeeping – which is the same way that banks run their businesses – so it’s a powerful way to cut through the confusion over what actually happens in QE. But double-entry bookkeeping can make your head spin because it involves lots of ALE – and unfortunately not the fun intoxicating kind, but the boring accounting trio of Assets, Liabilities and Equity.
The heart of accounting is the principle that the difference between the debts other people owe to you (your Assets) and the debts you owe to them (your Liabilities) is your net worth (your Equity). This is drummed into accounting students as the “Fundamental Equation of Accounting”: “Assets equal Liabilities plus Equity”.
Double-entry bookkeeping (DEB for short) enforces this equation in two ways. Firstly, it records any Asset as a positive amount, and Liabilities and Equity as negative amounts. Secondly, it ensures that any transaction between accounts sums to zero. So, for example, if a rich aunt died and left you $1 million in her will, your accountant would show that as your Assets changing by plus $1 million and your Equity changing by minus $1 million. It sounds counter-intuitive when you first learn it, but it works to make sure you don’t make mistakes when tracking financial transactions.
Minsky uses a similar approach: Assets are shown as positive sums, so assets are increased by adding to them – no big deal there. But Liabilities (and Equity) are shown as negative sums, so increasing a Liability involves subtracting from it (is your head spinning yet?). So a loan of $1,000 from a bank is recorded as plus $1,000 in its loan account – an increase in its Assets – and as minus $1,000 in your deposit account – an increase in its Liabilities to you. The sum across the row that records the transaction is zero.
Then Minsky assembles a model of financial flows from the economy’s point of view, in which everything is shown as a positive – just as the Federal Reserve does when it compiles its Flow of Funds record of the entire economy.
Boy, I’ve probably lost half my normal audience already – and probably to Ales of a different kind. But if the rest of you have survived that intro, let’s plug on and build a model of QE.
A model necessarily involves simplifications – otherwise you’d have a replica, not a model – and I’m using an extremely simple vision of a Central Bank. Firstly to acknowledge that it has an unlimited capacity to create money if it wants to, I’ve said that it has an Asset called a ‘Charter’ that lets it create as much money as it wants to. Then to balance its books following DEB, I’ve given it an Equity account that I label “Equity_FED” (for “Equity of the Federal Reserve”), and I’ve endowed this with an initial value that is the negative of the value of its Charter.
That leaves its liabilities to model, and as ‘the banker’s bank’ the Fed’s key liabilities are the deposits accounts of private banks – which economists call Reserves. Just to simplify the model, I set these as zero to begin with. So my model of the Fed in Minsky starts off looks like this:
When the US Federal Reserve first introduced its either/or stance on quantitative easing, I wasn't sure if it was a PR ploy or a serious plan.
Specifically, the Fed said it was prepared to increase or reduce the current $US85 billion-a-month pace of long-term asset purchases based on certain economic criteria. If the outlook for the labour market deteriorates, for example, the Fed might up the ante. Should hiring increase and inflation remain subdued, the Fed could taper its buying.
At his March 20 press conference, Fed chairman Ben Bernanke said "it makes more sense to have our policy variable", with purchases that respond to changes in the outlook.
To him, perhaps. If I understand Bernanke, he is saying that every six weeks policymakers will examine an array of leading, coincident and lagging indicators, most of which are revised and subject to seasonal distortions, to take the economy's pulse and reassess the forecast. From there, they will determine the appropriate amount of monthly bond purchases. This idea is as infeasible in theory as it is in practice.
Unlike the physician who uses real-time feedback to adjust the dose of a patient's medication, central banks operate in a world of long and variable lags. Their predictive models have a poor record. The continuation of quantitative easing has always been predicated on an improvement in "the outlook for the labour market", rather than an improvement in the labour market per se. Call it a better jobs market once removed. The inherent flaws in the theory should be apparent. As a practical matter, the plan is no more viable.
"The Fed doesn't have a methodological way of calculating the relationship between asset purchases, interest rates and the economy," says Jim Glassman, senior US economist at JPMorgan Chase & Co.
He's right. But you could say the same thing about the Fed's traditional policy tool, the federal funds rate, and the preference for adjusting it in 25-basis-point steps, according to Neal Soss, chief economist at Credit Suisse in New York.
Both have "the same element of science, judgment and trial and error", Soss says.
He's right, too. But interest rates are a lot more visible. The public knows when the central bank raises its benchmark rate – even if its relationship to the rates on home mortgages, car loans and credit-card debt remains something of a mystery – it costs more to borrow.
On the other hand, the public doesn't know, or care, about the size of the Fed's balance sheet, reported every Thursday. Even sophisticated traders have trouble understanding the implications. They heard Bernanke say "exit" in congressional testimony two weeks ago when the Fed is "still in the 'entry', or easing phase, of the policy cycle", Soss says. A reduced pace of asset purchases still qualifies as stimulus.
Only problem with the theory is they aren't printing money much more than they have since Basel Commenced.
The problem is money was piling up in the banks, because worthy risks didn't want to borrow and they curtailed risky lending to unworthy borrowers. So the central bank / government becomes borrower of last resort. Otherwise the M3 implodes and shrinks. They are willing to lend at low rates, but they narrowed the field who they lend to. The Prime directive here is the money must come back, especially because it's earning almost nothing in nominal terms.
So two things happened.....ZIRP and Central Bank/ government borrowing the static bank reserves to become buyer of the risky paper the commercial world don't want. Most of the reserves where not created, they are simply the ordinary savings the banks don't want to risk. So the taxpayer is the bunny, he takes the risk.
The next trick of our glorious banks will be to charge us a fee for using net bank!!! You are no longer customer, you are property!!!
Only problem with the theory is they aren't printing money much more than they have since Basel Commenced.
The problem is money was piling up in the banks, because worthy risks didn't want to borrow and they curtailed risky lending to unworthy borrowers. So the central bank / government becomes borrower of last resort. Otherwise the M3 implodes and shrinks. They are willing to lend at low rates, but they narrowed the field who they lend to. The Prime directive here is the money must come back, especially because it's earning almost nothing in nominal terms.
So two things happened.....ZIRP and Central Bank/ government borrowing the static bank reserves to become buyer of the risky paper the commercial world don't want. Most of the reserves where not created, they are simply the ordinary savings the banks don't want to risk. So the taxpayer is the bunny, he takes the risk.
Count, Officially at least the Fed is not buying any risky assets. Offficially, the fed is buying either:
1. The obligations of the United states Government or
2. It is buying de facto obligations of the United states government.
Officially therefore, the position of the United states government is better after QE because it is paying less interest.
Are you able to explain please, ideally with references, why you have written the following?
>>Central Bank/ government ......... become buyer of the risky paper the commercial world don't want.
It would help me in your answer if you can provide clear answers to the following.
What is the name of the risky paper you are referring to?
What is the name of the actual department of the central bank/government who is buying the risky assets.?
In what document are the risky assets and amounts involved recorded?
Count, Officially at least the Fed is not buying any risky assets. Offficially, the fed is buying either:
1. The obligations of the United states Government or
2. It is buying de facto obligations of the United states government.
Officially therefore, the position of the United states government is better after QE because it is paying less interest.
Are you able to explain please, ideally with references, why you have written the following?
>>Central Bank/ government ......... become buyer of the risky paper the commercial world don't want.
It would help me in your answer if you can provide clear answers to the following.
What is the name of the risky paper you are referring to?
What is the name of the actual department of the central bank/government who is buying the risky assets.?
In what document are the risky assets and amounts involved recorded?
Thanks
Andrew
Andrew- From the horses mouth
Record of Meeting of the Federal Advisory Council and the Board of Governors Friday, May 17, 2013
MBS purchases account for over 70% of gross issuance, causing price distortion and volatility in the MBS market. Fixed-income investors worry that attractive mortgage-backed securities are in very tight supply. Higher premium coupons carry too much exposure to prepayments, potentially led by new government support programs for housing. There is also concern about the possibility of a breakout of inflation, although current inflation risk is not considered unmanageable, and of an unsustainable bubble in equity and fixed-income markets given current prices. many are concerned about the Fed’s significant presence in the market. They have underweighted MBS in favour of corporate, municipal, and emerging-market bonds. Further, current policy has created systemic financial risks and potential structural problems for banks. Net interest margins are very compressed, making favorable earnings trends difficult and encouraging banks to take on more risk. The Fed’s aggressive purchases of 15-year and 30-year MBS have depressed yields for the “bread and butter” investment in most bank portfolios; banks seeking additional yield have had to turn to investment options with longer durations, lower liquidity, and/or higher credit risk. Finally, the regressive nature of the artificially compressed savings yields creates pent-up demand within bank deposit portfolios; these deposits may be at risk once yields begin to rise and competitive pressures increase.
Uncertainty exists about how markets will re establish normal valuations when the Fed withdraws from the market. It will likely be difficult to unwind policy accommodation, and the end of monetary easing may be painful for consumers and businesses. Given the Fed’s balance sheet increase of approximately $2.5 trillion since 2008, the Fed may now be perceived as integral to the housing finance system.
The case for individual freedom rests chiefly on the recognition of the inevitable and universal ignorance of all of us concerning a great many of the factors on which the achievement of our ends and welfare depend. It is because every individual knows so little and, in particular, because we rarely know which of us knows best that we trust the independent and competitive efforts of many to induce the emergence of what we shall want when we see it. Humiliating to human pride as it may be, we must recognize that the advance and even the preservation of civilization are dependent upon a maximum of opportunity for accidents to happen.” ― Friedrich A. von Hayek
"I, on the other hand, am a fully rounded human being with a degree from the university of life, a diploma from the school of hard knocks, and three gold stars from the kindergarten of getting the shit kicked out of me." Blackadder.
Record of Meeting of the Federal Advisory Council and the Board of Governors Friday, May 17, 2013
MBS purchases account for over 70% of gross issuance, causing price distortion and volatility in the MBS market. Fixed-income investors worry that attractive mortgage-backed securities are in very tight supply. Higher premium coupons carry too much exposure to prepayments, potentially led by new government support programs for housing. There is also concern about the possibility of a breakout of inflation, although current inflation risk is not considered unmanageable, and of an unsustainable bubble in equity and fixed-income markets given current prices. many are concerned about the Fed’s significant presence in the market. They have underweighted MBS in favour of corporate, municipal, and emerging-market bonds. Further, current policy has created systemic financial risks and potential structural problems for banks. Net interest margins are very compressed, making favorable earnings trends difficult and encouraging banks to take on more risk. The Fed’s aggressive purchases of 15-year and 30-year MBS have depressed yields for the “bread and butter” investment in most bank portfolios; banks seeking additional yield have had to turn to investment options with longer durations, lower liquidity, and/or higher credit risk. Finally, the regressive nature of the artificially compressed savings yields creates pent-up demand within bank deposit portfolios; these deposits may be at risk once yields begin to rise and competitive pressures increase.
Uncertainty exists about how markets will re establish normal valuations when the Fed withdraws from the market. It will likely be difficult to unwind policy accommodation, and the end of monetary easing may be painful for consumers and businesses. Given the Fed’s balance sheet increase of approximately $2.5 trillion since 2008, the Fed may now be perceived as integral to the housing finance system.
ETR
The fed is only buying agency MBS
The feds agency MBS purchases are all either
1. Direct liabilities of the US government or
2. De facto liabilities of the US government
Therefore there is no risk of any substance that matters to the banks who originate these mortgages.
Therefore there is no risk of any substance that matters to the banks who originate these mortgages.
Andrew- You are looking at one dimension of the policy. Even the Fed realises their purchases are pushing banks out along duration and risk to find yield.
Look at the junk market a perfect example of where the policy has created a risky bubble
Junk carries a high probability of default hence the name. The systemic risks and bubbles created by QE are very obvious, only pointy head academics cannot see them.
Oh, and just to make sure we are on the same page, the banks who have now bid this Junk are SIFI's and therefore ultimately are destined to be bailed out by the same FED who you contend only has safe assets on it's balance sheet.
The case for individual freedom rests chiefly on the recognition of the inevitable and universal ignorance of all of us concerning a great many of the factors on which the achievement of our ends and welfare depend. It is because every individual knows so little and, in particular, because we rarely know which of us knows best that we trust the independent and competitive efforts of many to induce the emergence of what we shall want when we see it. Humiliating to human pride as it may be, we must recognize that the advance and even the preservation of civilization are dependent upon a maximum of opportunity for accidents to happen.” ― Friedrich A. von Hayek
"I, on the other hand, am a fully rounded human being with a degree from the university of life, a diploma from the school of hard knocks, and three gold stars from the kindergarten of getting the shit kicked out of me." Blackadder.
Andrew- You are looking at one dimension of the policy. Even the Fed realises their purchases are pushing banks out along duration and risk to find yield.
Look at the junk market a perfect example of where the policy has created a risky bubble
Junk carries a high probability of default hence the name. The systemic risks and bubbles created by QE are very obvious, only pointy head academics cannot see them.
Oh, and just to make sure we are on the same page, the banks who have now bid this Junk are SIFI's and therefore ultimately are destined to be bailed out by the same FED who you contend only has safe assets on it's balance sheet.
ETR
We are having a misunderstanding.
We seem to be in clear agreement the Fed is not yet buying the banks risky assets.
We seem to be in clear agreement the Fed is not yet buying the banks risky assets.
Andrew, the most important factor is not the composition of assets on the Fed's balance sheet.
The effect of the Fed purchasing 85 billion dollars worth of assets is really what we should be focussed on. Bubbles have been blown in the debt markets including Junk and Sovereign (Italy, Spain, France etc). Equity markets and REIT's, just to name a few.
Sure the assets on the Fed's balance sheet may be sound, but the assets on the SIFI's the Fed will ultimately be accountable for now represent similar risks which led to the GFC. It is not a point lost on the Fed.
Enjoy The Ride!
The case for individual freedom rests chiefly on the recognition of the inevitable and universal ignorance of all of us concerning a great many of the factors on which the achievement of our ends and welfare depend. It is because every individual knows so little and, in particular, because we rarely know which of us knows best that we trust the independent and competitive efforts of many to induce the emergence of what we shall want when we see it. Humiliating to human pride as it may be, we must recognize that the advance and even the preservation of civilization are dependent upon a maximum of opportunity for accidents to happen.” ― Friedrich A. von Hayek
"I, on the other hand, am a fully rounded human being with a degree from the university of life, a diploma from the school of hard knocks, and three gold stars from the kindergarten of getting the shit kicked out of me." Blackadder.
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