What Is QE And What Does It Portend? Probably Less Than You Think

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 |  Includes: SPY
by: Martin Lowy

What does all this QE stuff actually mean? Is it going to cause inflation? Is it going to devalue the currency? Will it in fact spark an economic recovery and more jobs? It is quite mysterious. Yet I read articles every day claiming it will do all those things and more.

The Transaction

In the current round of QE (Quantitative Easing), dubbed the third such round, the Fed will buy primarily U.S. agency securities in the open market. The sellers could be banks, insurance companies, pension funds, hedge funds, the Chinese government or just plain rich folks.

Here is what happens when the Fed buys a Fannie Mae (FMNA.OB) security worth $1 million.

The Fed gets the security transferred to the Fed's account at Fannie Mae's transfer agent. The Fed credits a bank's account at the Fed with the $1 million to pay the seller. The Fed's bank transfers the dollars to the seller's bank, which credits the seller's account. There are three net effects: (1) the banking system has grown by $1 million of demand deposits, which $1 million now is held in the seller's bank account at the Fed. (2) The seller now has a demand deposit instead of a Fannie Mae bond. (3) The Fed now owns a Fannie Mae bond and will collect the interest and principal payments on that security.

The Immediate Consequences

If everything stays the same forever, the seller's bank receives whatever rate of interest the Fed pays on deposits (called excess reserves, just to be confusing) and the seller's bank pays the seller whatever it pays on the seller's account. There is not much difference between the two in most cases. Probably the bank will make .25% annually under current conditions. The bank will not require additional regulatory capital because the regulatory capital requirement for a deposit at the Fed is zero.

The Fed now has an income stream from the Fannie Mae security that is substantially greater than the .25% per annum that it will pay the seller's bank on its deposit, so the Fed will make money on the deal. (The Fed's earnings are passed along to the Treasury at the end of each year. Therefore the deal reduces the Federal government's deficit in the short run.)

What has happened to the money supply? What has happened to the Federal government's debt? The money supply, as defined in M1 or M2, has increased by $1 million. But since that $1 million is sitting in an account at the Fed, it has not affected the economy in any way. It is just a book entry. In that sense, changes in the money supply sometimes are meaningless, at least in the short term.

Nothing is also what has happened to the size of the Federal debt. The Federal government owns and guarantees the debt of Fannie Mae. (Yes, I know there are fictions that cover this up from an accounting point of view, but that is the fact.) The Federal government also owns the Fed in every meaningful sense. Therefore the Federal government issued the bond that the Fed bought with money that it created, and the money that the Fed created also is an obligation of the Federal government. The real net debt of the Federal government has not changed as a result of the transaction. Only its tenor has changed. In place of the Fannie Mae security that had a duration and an interest rate, the Fed has substituted a demand deposit that has instant maturity and an interest rate that it can peg at will, currently .25%. The net result to the Federal government is that its average maturity of outstanding debt has shortened. That is all. It is the same as Operation Twist, in which longer maturity government bonds are swapped for shorter ones.

The Next Step

So far, this transaction has had no apparent impact on the economy.

The next step is that the seller of the Fannie Mae security decides that leaving the money in the bank earning nothing is not the best idea. A substantial percentage of sellers will reach this conclusion. Their choices, since they mostly are institutions, will be among various types of investments. They are not likely to buy another Fannie Mae bond with the proceeds. They also are not likely to buy even-lower-yielding Treasury securities, although some will do so. Some will buy corporate bonds for their higher yields despite greater credit risk. Some may buy foreign bonds, taking currency risk. Some will venture into the equity markets. Some will buy gold. The prices of these alternative investments are likely to go up somewhat as a consequence. If stock prices go up, that may help the economy. If more corporations are induced to issue debt securities, they may use that money for productive purposes and help the economy or they may use the debt-generated money to create higher financial leverage by buying back stock or making acquisitions, neither of which benefits the economy. Thus, some benefit to the economy is likely to result.

Impact on the Federal Government

Longer term, the Federal government as a whole will have traded long-term obligations for short-term obligations at a time when it could have raised long-term money quite cheaply. It will make money on the deal in the short run but may pay dearly if inflation ensues. Corporations are raising as much long-term money as possible and paying down short-term debt; through QE, the Federal government is doing the opposite.

Impact on the Banks

Coming back to the banks: Recall that an impact of the transaction is that the banking system has gained $1 million in deposits at the Fed. The banks that hold those deposits could decide to lend them at higher interest rates. But at this time, banks are not doing that. They are leaving their excess reserves at the Fed. They are doing that because, in their judgment, there are no creditworthy borrowers that are looking for loans. And the bank will not make unprofitable or risky loans because doing so will increase their regulatory capital requirements without giving them a corresponding benefit. For this reason, the banks are unlikely to increase their lending just because they have excess reserves.

As an historical note: Banks used to be constrained in their lending by reserve requirements, so when the Fed injected reserves into the system, banks lent more. Banks are no longer constrained by reserve requirements. Therefore injecting reserves into the banking system is a practically meaningless act at this time.

Summary

The net effect is that the Federal government gets a short-term benefit from QE but takes a long-term interest rate risk. The Fed's balanced sheet starts to look like a 1970s S&L balance sheet: Long-term assets funded by short-term liabilities, which will not be good if inflation ensues. Maybe the Federal government can afford that risk better than a private party could.

But inflation is not likely to be generated by creating money that sits in a deposit at the Fed. That money has a zero velocity.

The economy may benefit from the investments that the seller of the Fannie Mae security makes with the proceeds, but that is hypothetical. The economy may benefit from pushing down long-term interest rates. But there are trade-offs to that in the form of lower earnings for savers and institutions such as pension funds, insurance companies, and endowments. These investors may be induced to take greater risks than were presented by the Fannie Mae government-guaranteed bond, and in some year, those risks may come to pass and all those institutions will be in the soup, as will their investors and beneficiaries.

All in all, QE seems to have less benefit than its champions proclaim and less detriment than its detractors forecast. QE seems to move markets, but my guess is that that is more psychological than anything else. The numbers sound large if you don't treat the Federal government as a whole and do the netting or if you are wedded to the idea that more money supply necessarily means more lending or future inflation.

What It Might Mean for Us Chickens

What does this mean for those of us who depend on our investments to fund our retirements or to protect our wealth? It tells me that the stock and bond market rallies of the last two years are built on quicksand. A market that goes up because of psychology eventually will go down because of psychology, and markets always overshoot because of psychology. If somebody authoritatively says that the emperor is not wearing any clothes, many investors will head for the hills. Risk-off will be the fashion, and those that are too heavily in stocks or long-term debt will lose a lot of money. Even our greatest companies, like Apple (NASDAQ:AAPL), will have their stock price affected. But how long it will take before that happens, I do not know. It could happen tomorrow. Or it could not come for years. But what date is the third Monday of October this year?

Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.