Hi,
I would like to know the mechanics of “Quantitative Easing”. I read the following article but it didn’t really explain the process fully.
"Quantitative easing (QE) is one way in which the Fed prints money, *Bianco says, suggesting the Fed “pays” for securities owned by banks by just changing the amount of money in their reserve accounts. “We live in a fractional banking system,” he says. “When banks have more reserves and ability to lend that is a form of money creation.”
*Jim Bianco, president of Bianco Research
Please explain the mechanics of this. How exactly does the Federal Reserve bank convert banks’ reserve assets into cash to then pump it into the economy.
I look forward to your feedback
davidmich
My understanding is that the Fed buys back bonds from the banks.
Normally, when the Fed wants to stimulate the economy they lower interest rates. In the wake of the financial disaster of 2008 they lowered interest rates to nearly zero, but it didn’t stimulate the economy enough. Interest rates can’t go below zero, so they had to resort to other means of stimulus. Quantitative easing - the buyback of bonds - puts the banks in the position of having a bunch of cash. Rather than leave it as cash, which doesn’t make them any money, they invest it by loaning it out.
I think you need to post a specific question. Your thread title asks how QE works, but then you’ve posted two links that explain how it works with a fairly cryptic “this is what I’m getting at?”
It’s not clear what your question is.
My question is about the mechanics of buying back bonds and then monetizing them.
davidmich
The mechanics is to get home prices up to levels where people can get out of being underwater, which severely dampens the economy.
Conventional monetary policy in the US operates chiefly via open market operations. That involves buying treasury bills and bonds, in exchange for money. Via the money multiplier, the money supply increases. And short term interest rates drop. Specifically the Fed funds rate.
What happens when the Fed funds rate is at or near zero? Once conventional monetary policy is maxed out, Bernanke went into experimental mode (properly IMO). QE refers to purchases of longer term bonds and mortgage securities after the fed funds rate has hit zero. The idea is to a) drive up bond prices so interest rates on longer term debt fall and b) drive down spreads between safe assets (Treasuries) and everything else.
a) is conducted by eg buying 30 year Treasury bonds.
b) is conducted by eg buying mortgage securities which are riskier than treasury debt.
Whew. Hope that helps.
There are other unconventional approaches btw.
Thank you all. You’ve been very helpful
davidmich
It’s very simple.
Every time US Government issues a bond that says $100 on it - it is an amount added to the total amount of money in circulation. Someone – commercial banks or institutional investors – buys that bond by handing over $100 cash to the US Government so that they can spend it. They come up with money by collecting deposits and then leveraging deposits to some ratio (say for every $1 of deposit they invest $10 would be 1:10 ratio but it can get stretched to 1:40).
At one point, US Government is nearly choked to debt by new requirement to issue more bonds so that they can spend it plus the amount of interest they need to pay for already issued bonds.
So, how do you give a US Government a break?
By having Feds buying existing bonds. How? Because they can!
It’s like you owe a mortgage, a 2nd mortgage, credit line of $20K, lease payments on two cars (annually for another $20K) and now you want to buy a third car.
You look at your data and you see that if you do that you won’t be able to pay for food as simply there is no sufficient amount of income to sustain all that.
So what do you do?
You get Feds to buy your 2nd mortgage and pay half of your credit line and help you with 30% of your 2nd car and suddenly you look “healthy” and you go on and buy a 3rd car.
The hope is that in 6 months or 7 years you will get a bonus or salary increase or you’ll win lotto.
That’s it pretty much.
davidmich, is your real question: How is it even possible for the F.R.B. to “create money out of thin air”?
If so, this has been touched on in several previous threads. The short answer is that “money,” whether in the form of paper or electrons, just isn’t as solid or tangible as you may think it is!
The problem with QE (we’re on QE 3 right now) is that about 2/3 of the money the fed has created is stashed away in excess bank reserves and therefore invisible to the economy. As a result, the observed multiplier is roughly .75 as opposed to it’s historical average of 2-3. IOW, the impact of each additional dollar the fed creates on the economy is not exactly negligible, but not very impressive either. If you ever the expression ‘pushing on a string’ this is what they’re talking about. At some point, stuffing more dollars into the system only has a limited effect.
The question of why this happens to be the case is one that is still open. Part of it is the fact that companies are choosing to finance operations with bond issues rather than loans - probably due to historically low interest rates and the fact that they have tightened up their balance sheets considerably in the wake of the recession. Those that survived are financially healthy. As a result, there is less of a demand for traditional bank loans. On the other side, banks have tightened their underwriting standards and are much more risk averse. Therefore even in cases where there is a demand for loans, the more stringent criteria they impose means that fewer loans will be approved.
The idea behind QE is that increasing the money supply makes money cheap (decreases rates) and encourages capital investment which stimulates the economy. However money being cheap is only an effective stimulus if there is a demand for money and if the financial infrastructure is willing and able to lend.
The previous phase (ended Dec 2012) was actually a little more complicated. Operation Twist was designed to drive up short term rates and drive down long term rates. This flattened the yield curve - the spread across short and long term maturities. This was accomplished by selling short term bonds the fed had on its balance sheet already and buying long term US treasuries and MBSs. Selling more of a bond drives down the price and therefore increases the yield - and vice-versa.
Right now, the $85B the fed buys in bonds per month is a mix of roughly half USTs (treasuries) and half MBSs.