“Quantitative Easing” is a form of monetary policy the Federal Reserve executes to help meet its policy objectives. QE has been widely talked about since QE1 was announced in November 2008. The Federal Reserve has always had policy targets and has used various forms of monetary policy to reach them.
QE is a type of open market operation that alters the reserves in the banking system. The altering of these reserves helps the Fed achieve its target interest rate. Before I go too far into the intended effects, I would like give a basic example of the QE process.
A Quantitative Easing Transaction Example
The primary transaction that has occurred is when a bank sells t-bonds to the Fed.
Federal Reserve Balance Sheet
Change in Assets = +$100M t-bills
Change in Liabilities = +$100M reserve liabilities
Change in Net Worth = $0
Banks Balance Sheet
Change in Assets = $0(t-bond is swapped for reserves)
Change in Liabilities =$0
Change in Net Worth =$0
After this transaction is complete, the bank still has the same net worth as before QE. The medium switches the composition of the balance sheet assets, but does not add assets. The process changes the composition of private sector balance sheets. The Fed, through open market operations, is switching private sector assets from t-bonds to reserves. In theory, it would be like me giving you five $20 bills for a $100 bill. Your net worth will have not changed as a result of this transaction. Although you might have more liquidity.
So how does QE help the Federal Reserve achieve its target policies? By shrinking the supply of US government bonds, the Fed is putting downward pressure on interest rates by increasing the demand for other bonds. The increased demand can lead to price increases and portfolio rebalancing. This phenomenon is often referred to as “wealth effect” which could lead to an increase in private sector net worth through asset appreciation. The interest rate channel can also spur investment by helping to maintain an accommodative interest rate structure.
The psychological impact of QE is one of the most important and unpredictable impacts. QE has the potential to cause asset price appreciation as monetary policy remains accommodative. The private sector might feel more comfortable to invest while the Fed is accommodative. The largest effects of QE are indirectly caused by bond purchases.
Many people have called quantitative easing “money printing” and some have gone as far to say the U.S is monetizing its debt. However, the execution of QE would have been exactly the same even if the U.S where to have a budget surplus. If we would have performed QE while having a budget surplus, we would not have heard the claims of the U.S monetizing its debt. Many individuals have bought into the debt monetization myth. However, the Treasury is not financing the government’s spending. This can be seen by looking at the QE impact on the Fed’s balance sheet. The idea of debt monetization would give me concern for inflation. However, this is not a concern because the Fed is buying bonds on the secondary market that have already been purchased. Further, it is implementing these transactions, not because there is a lack of demand for t-bonds, but because the Fed is trying to reach its policy targets.
What is the theory behind QE? The theory behind the mechanism is banks will have more reserves which will spur them to lend out more money. Fundamentally, there is a bit of an issue with this theory. Banks do not lend out reserves to the public. Before a bank makes a loan, they never check their reserves. They make loans to qualified applicants and reserves are continually managed. If a bank needs more reserves, they can obtain them from the central bank after the fact. Bank lending is not restricted by the level of reserves. Consequently, increased reserves will not translate into more loans unless there is an increase in qualified loan applicants. Bank lending is driven by creditworthy applicants. A greater supply of reserves does not necessarily mean that more loans will be made.
When the Federal Reserve shifts assets around in the private sector, it can cause investors to move from one asset to another. This behavior can push asset prices higher as investors rebalance portfolios. Although asset prices rise, the underlying fundamentals of the assets may not improve as much as the market is pricing. It is unknown if the rise in asset prices is justified. Investors will find out as time goes on. The psychological and behavioral effects are prominent as investors have felt increased confidence from an accommodative Federal Reserve. The obsession with forward guidance and the Fed’s dot plot has been beneficial in setting expectations but it has also put a spotlight on the credibility of the Fed. There is a risk of a scenario where the Fed’s forward guidance is inaccurate and they are forced to act in accordance with it even though circumstances have changed. Alternatively, they risk shocking the market and revising forward guidance. These circumstances are indirectly caused by QE.
The effects of QE are still predominantly unknown. The operation helps the Federal Reserve achieve its target policies similar to other forms of monetary policy. QE can be executed in many ways by adjusting the asset being purchased. This can alter the effects of the operation. Many central banks around the world are now experimenting with QE in various ways. Only time will tell if there will be long-term consequences to these monetary policy actions.
Negative Interest Rates
Negative interest rate policy (NIRP) is a much easier concept than Quantitative Easing. The idea is that central banks will charge banks interest for holding reserves; incentivizing them to lend more. Many foreign central banks—such as the European Central Bank, the Bank of Japan and the Swiss National Bank—have implemented negative interest rates on bank reserves as a policy tool. This central bank policy forces banks into a corner. The banks are left with a few different options. 1) Lower interest rates on loans in hopes of increasing demand. 2) Charge customers a fee for holding deposits which passes the cost onto them. 3) Charge customers higher fees for processing loans, passing the cost onto them. 4) Do nothing and have lower net income which will hurt their stock prices. As previously mentioned, bank lending is driven by creditworthy borrowers. Charging banks interest on reserves will not alter the population of creditworthy borrowers. No matter which option each respective bank chooses, the end result is a tax that reduces interest income for the private sector.
The scary thing about negative interest rate policy (NIRP) is it pushes banks to lower lending standards. Because the population of creditworthy borrowers will not change, they must change the definition of “creditworthy” to shift the demand curve. This is obviously dangerous as the interest rates of new loans will not align with the risks the bank is taking.
As of today, the Japan 10 year government bond (JGB) has a yield of -0.12%. Why would someone buy a bond with a negative yield? Investors chasing short term performance believing yields will continue to fall might purchase bonds for the price appreciation. In the long term, the issuer of the bond will still be paid the negative yield. However, investors betting on deflation and lower rates might purchase these bonds for short term performance.
The world has now been exposed to NIRP for long enough that banks are beginning to react to the policy. As mentioned, they are being put into a corner and must decide the best course of action. We have seen numerous banks begin to charge clients for deposits. Negative interest rates have started a game of hot potato within the banks. As one bank begins charging customers for deposits, the customers move deposits to another bank. Deposits move from one bank to another as more implement charging for deposits. Many economists believe that banks can’t force depositors to hold less deposits. I would argue there is a tipping point but we have no idea where it is. Warren Buffett commented on this issue after the Berkshire Hathaway annual meeting last month. He said “It’s a different world. If you have a lot of money in euros, as we do … you’re better off putting it under your mattress than in a bank.” This is indicative of the hot potato being passed around. Ultimately, deposits held in banks will essentially be taxed and money will flow from the private sector to governments. If depositors pull their currency out of the banking system, they are exposing themselves to having their money lost or stolen. The question is, how much can people be taxed on their deposits before they pull them out of the banking system?
Negative interest rate policy is a scary operation to continue. Bank dynamics contradict the policy’s theory. Incentivising or pushing banks to lower lending standards to spur lending seems dangerous. In the end, the result of the operation is the same, interest is flowing out of the private sector to the government. Whether banks decide to pass the cost onto their depositors is their choice. However, someone in the private sector will have to foot the bill.