This week the Fed announced it will continue its 85 billion dollar per month purchases of U.S. Treasury and Mortgage Bonds. Financial television watchers were then treated to the usual banter of pundits accusing the Fed of "money printing," creating money out of thin air and pumping it into the economy. Google the phrase "money printing" and you'll get page after page of articles on the Fed, quantitative easing(QE), and "money printing." Clearly, the Fed must be printing and pumping money, after all, if something is repeated enough it must be true.
But, surprise, it isn't legal for the Fed to create money. So, if it is not authorized, how is it doing it? The answer is, it is not. True money printing occurs when the deficit of the United States is financed through the issuance of new uncollateralized currency. In this case, instead of issuing bonds the Treasury would just print up new United States Notes and pay its bills. Depending on the tax rate, that could create inflation. But, that is not what is going on with QE.
This is important for investors. If you make predictions, based on a premise of Fed money printing, but the Fed isn't actually creating money, you will make bad predictions. Bad predictions in investing usually lead to bad results.
The Money Supply
If the Fed is actually printing money, it will show in the data. Look at the M2 money stock for the last 10 years. If the Federal Reserve were creating money, there should be an upward kink in the green line below, but there isn't. The line is straight. The money supply is growing at the same rate it always has, which is roughly the rate of population and economic growth. However, its velocity, the rate that it changes hands, is slowing. The lower circulation velocity is one of the reasons the economy is in the doldrums. To raise economic output one or both of the variables must increase, as nominal GDP is the money supply times the velocity.
Exhibit 1: Steady M2 Money Growth(green) and Declining M2 Velocity(blue).
The Fed's monetary actions are increasing bank reserves (M0), but the reserves aren't counted as part of the M2 money supply because they don't circulate.
But looking at the broader M4 money supply, which does include the reserves, the supply it is even worse (Exhibit 2). It is off trend, flat, and not growing with the economy and populations. The Fed money is represented as M0 in the graph below.
Almost all of our money, about 85%, is not from the government. It is from private banks loaning money to private citizens. That's why the money supply graphs are not increasing. During the financial crisis we had a lot of loan defaults. This removed money from the system. Loans create money and defaults destroy it. This reaction is represented by the downward slope of the M4 money supply starting in 2009. Banks haven't wanted to loan aggressively so the money supply is flat.
Exhibit 2: Divisia M4 Broad Money Supply
(Courtesy Steve Hanke, Center for Financial Stability)
You won't learn this from television, but the Fed isn't printing too much money, instead the economy is starving of money. The M4 supply must regain its upward slope and unfortunately the Fed is powerless to control it. The Fed can make it easier for banks to loan, but the Fed can't make them loan. As Yogi said, "if they don't want to go to the ballpark, you can't stop them."
A Short History of Paper Currency
If the Fed can't legally manufacture money, then what is it printing when it engages in Quantitative Easing? It is in essence issuing Federal Reserve Notes, which are a type of national banknotes, that, in turn, are a type of promissory note. To better understand what QE is and what the Fed is doing it helps to understand paper currency, because the Fed is in the paper currency business. The U.S. works on a banknote system. Before, the Fed all of our paper currency was issued by private banks. A short history will help to understand what the Fed is creating.
National Bank Notes - From 1862 until 1938, National Bank Notes were produced by many banks throughout the country. The notes are commonly called bills of credit or bills. This is a 50 Dollar Bill of Credit. Before the establishment of the Federal Reserve, they functioned as our national currency.
Below is an example of one issued in 1929 by the National Bank of Canton, Maryland. Banknotes are promises to pay the bearer "lawful money" if he or she goes to the issuing bank and demands it. The bank kept the heavy coins, the customer got a convenient note. They are sort of like a check that anyone can cash.
A common problem with early banknotes was banks didn't trust one another and would charge exchange fees. If they thought another bank was insolvent, they would refuse the notes outright. Sort of the same hassle you get if you try to cash a check without having an account at a bank. To remedy this, chartered national banks were required to secure their notes with risk-free U.S. Bonds deposited at the U.S. Treasury. The bank sent bonds and the Treasury sent a like number of blank National Bank Notes to the bank. The notes are obligations of the issuing bank, backed by U.S. Bonds on deposit at the U.S. Treasury. This way the accepting bank would know that the issuing bank had the money to cash the note.
There was no wealth created when the bills were issued, money was used to buy bonds and the bonds were deposited. The bank doesn't have more assets after it gets the new banknotes. Bonds were simply replaced with bills.
Exhibit 3: National Bank Note
(click to enlarge)
Notice below the National Currency title, it states in very small print "secured with United States Bonds deposited with the treasurer of the United States of America." As required by law the bank has collateralized the note with United States Bonds deposited at the U.S. Treasury. On the left side it says the bank "will pay the bearer on demand Fifty Dollars." And over the red seal in more fine print, the note is "redeemable for lawful money at the United States Treasury or the Bank of Issue." Lawful Money under the Federal Reserve Act is coins or United States Notes. After 1933, lawful money also included Federal Reserve Notes. If you demand it, the bank will exchange this bill for coins or United States Notes.
Exhibit4: United States Note
(click to enlarge)
United States Notes - these notes, known as greenbacks, or legal tender notes, were issued by the Treasury from 1862 until 1971; they are direct obligations of the U.S. government. Since they are issued by the Treasury, it didn't make much sense to collateralize them with Treasury Bonds. If you cashed this one at the Treasury it would give you five dollars in coins. If you think of the government as corporation, you can think of Federal Reserve Notes as a bond and United States Notes as stock. These notes look just like a Federal Reserve Note, but they have a red seal. If we used U.S. Notes instead of Federal Reserve Notes we could fund the government without debt, just like a corporation, by issuing stock, can fund itself without debt. But, during the Civil War, Congress limited their issuance to 450 million, a limit that still stands.
Exhibit 5: Federal Reserve Bank Note
(click to enlarge)
Federal Reserve Bank Notes - Under the Federal Reserve Act individual Federal Reserve Banks could issue banknotes. Here is a similar looking Federal Reserve Banknote issued by the Federal Reserve Bank of Kansas City. These notes were issued from 1914 until 1945. This note has a brown seal. It is similar to a National Bank Note except below the United States of America line it broadens the security by adding "or by like deposits of other securities." Like the National Banknote above, it is also redeemable in "lawful money." These banknotes were secured with U.S. Bonds and like deposits, and were issued by any of the 12 individual Federal Reserve Banks. They are obligations of the issuing reserve banks and were produced until 1945.
Federal Reserve Notes - The main difference between a Federal Reserve Bank Note and a Federal Reserve Note is the former is an obligation of the individual reserve bank and the latter is an obligation of the United States. Federal Reserve Notes were first issued in 1914, and until 1933 were exchangeable for lawful money or gold. They are legal tender, which can be used legally to extinguish debt. Federal Reserve Notes are issued collectively by the Federal Reserve system and are obligations of the Federal government.
For whatever reason, the Bureau of Engraving has dropped the fine print about the secured deposit of U.S. Bonds and like deposits. The "will pay the bearer on demand" was dropped years ago, as was the line about redeeming the bill for lawful money. In 1933, Congress declared them lawful money.
Regardless of the lack of fine print, the process of issuing banknotes was not changed. Federal Reserve Notes are still secured with U.S. Bonds or like securities, and if you take one to the Treasury, it will give you lawful money, a coin or another Federal Reserve Note. It will make change.
Understanding QE requires understanding the security behind our money. Because we are no longer reminded of the security arrangement on the actual bills, many people, including television journalist, don't precisely understand what they are carrying in their pockets and what exactly the Fed is doing.
For investors to make good financial predictions, they should understand QE. To do this, it helps to know what the Fed is printing. Issuing banknotes is not the same as creating money. The Fed must reserve as collateral a U.S. Bond or like security when it issues notes.
The Mechanics of Quantitative Easing
Before we get to QE. It is important to understand the mechanics of how the Fed issues money on a day-to-day basis. Since it can't print money, the Treasury does that, if a bank needs more currency the Fed will order Federal Reserve Notes from the Treasury. The bank has reserves at the Fed backed by an equal quantity of bond collateral so that the Fed balance sheet balances. When the bank wants more Notes, the bond collateral is sent to the U.S. Treasury, the Notes are then printed by the Bureau of Engraving, and sent to the Fed. The Fed issues the bills to the bank and the bank's reserve account is debited an equal amount. The Bank has more Notes and fewer reserves.
When it engages in QE, the Fed does, more or less, the same thing only backward. First, it buys U.S. Bonds on the open market. and using the bonds for collateral, it issues a check to the seller. The money for the check is backed by the purchased bonds. The seller's check gets deposited in a bank and clears through the Fed. When the check clears, the Fed credits the reserve account of the submitting bank. The Fed now owns a bond for collateral and the bank has additional reserves. The newly purchased bond collateralizes the bonds. In this case, the bank has more reserves, the Fed has more bonds and the economy has fewer bonds. The seller has a bill instead of a bond, but isn't any richer. Because the seller isn't richer, the process is not inflationary.
The issued Note is always "secured by United States Bonds." For every dollar Reserve Note issued, the Fed must have on its balance sheet one dollar in United States Bonds or like securities. For all the rhetoric, the Fed cannot drop money from helicopters. The Fed can't print a bunch of uncollateralized money and give it away. It cannot create money. QE is simply an asset swap. It exchanges interest paying United States Bonds for non-interest paying Federal Reserve Notes.
Therefore, QE is not money creation and the Fed is not pumping money into the economy. It is simply converting assets. It is not inflationary.
How does QE affect the economy?
When the Fed buys a U.S. Bond with Federal Reserve Notes, or more accurately reserve credits, it has two important effects within the economy and one unimportant effect.
First, it removes the number of US Bonds in circulation, lowering the available supply and placing upward pressure on bond prices and downward pressure on interest rates. Because of this the money that might have been invested in Treasuries and MBS, must be saved or invested elsewhere, like the stock market. This increases the price pressure on those assets and lowers interest rates. The purchase of mortgage-backed securities lowers the interest rate on home mortgages. In a sense the Fed is engaged in bond destruction, not money creation. This is inflationary for bond prices.
Second, it removes government interest payments from the economy. The interest paid on the bonds is sent back to the U.S. Treasury. Last year, the Fed sent back 88 billion dollars to the Government in interest payments. That is 88 billion dollars in interest income that was not released into the economy. In a sense, the Fed is actually removing money from the economy, not printing it. This is part of the reason our money supply is flat.
The last effect, which is not important to the economy, is the Fed is increasing bank reserves(M0). Bank reserves are not within the economy, they are just accounts member banks hold at the Fed, a little like a checking account at the bank. In the old days, banks needed reserves to loan out money. They needed to hold back a percentage of their loans at the Federal Reserve Bank. But, in modern times the reserve ratio is effectively zero and the mechanics of modern money allow the loans to generate their own reserves. Loans issuance at modern banks is only constrained by the bank's ability to find profitable creditworthy borrowers.
In sum, QE reduces bond inventory, lowers interest rates, removes interest payments, and increases bank reserves.
No Money Creation
With Quantitative Easing the Fed is buying bonds and issuing banknotes. This is not money creation. It removes wealth from the economy, with the purchase of U.S. Bonds and then injects an equal amount of wealth in banknotes. It is a wealth neutral asset swap.
It is no different than selling a U.S. Bond in your brokerage account. In that case, the brokerage house would debit your account for the bond and credit your money market account with cash, but your balance wouldn't change. You don't have more money. Likewise for QE, when the process is over, the economy doesn't have any more money.
Inflation: If the Fed simply created money out of thin air and gave it to people, it would be inflationary, because it adds new assets to the economy, and devalues the old ones. If the Fed issues reserve notes and simultaneously removes a U.S. Bond it is not inflationary, because the asset level remains equal. If you buy Treasury Inflation Protected Securities (TIP) on the premise that the Fed is engaged in money printing, and the money printing will be inflationary, you will be disappointed. Instead, look for inflation to increase when velocity increases, or the rate of change of the money supply increases.
Deflation. The velocity of the money supply is the lowest it has been in 50 years and is still declining (Exhibit 6). The broad money supply M4 is flat (Exhibit 2) Labor force participation is 6% off of its most recent peak (Exhibit 7). Government spending is flat and likely to be sequestered lower (Exhibit 8). These factors all add up to a slow or zero-growth economy with significant deflationary pressures. As long as there are deflationary pressures interest rates will remain low and the Fed will be likely to maintain its QE policies. Long-term bonds do well in deflationary environments.
Exhibit 6: M2 velocity of circulation at 50-year low
(click to enlarge)
Exhibit 7: Low labor participation means low wage pressure
Exhibit 8: Government Expenditures flat and likely to be sequestered lower.
Stocks: A shortage of bonds requires investors to seek other places to invest their money, including the stock market. The market is on an upward trend. Lower interest rates reduce the cost of investment and deflationary pressures increase the supply of workers keeping labor cost low. Low cost of capital and labor translate into higher profits helping to maintain or improve earnings.
The stock market has headwinds. It is unlikely the record profits can be maintained in a slow-growth economy. A strong market has driven P/E higher and Current high P/E and Tobin q valuations leave little upside for P/E expansion. Without P/E expansion stocks are only OK investments. Without a growing E, it will be worse. How long the market will climb this wall of worry is unknown.
In a mildly deflationary low-growth environment, like now, portfolios over-weighted in less interest sensitive bonds that pay a higher-coupon can give investors strong returns with less risk than portfolios with a heavy equity weight.
Exhibit 9: Cyclically-Adjusted Price Earnings and Tobin q Valuation
(click to enlarge)
(Courtesy of Smithers & Co.)
Additional disclosure: This article is for informational and educational purposes only. The views expressed in this article are the opinions of the author and should not be interpreted as individualized investment advice. Investment objectives, risk tolerances and the financial situation of individual investors may vary. Please consult your financial and tax advisors before investing.