Questioning the QE Monetary Transmission Mechanism

by: Ronald Rutherford

The Fed’s Quantitative Easing policy (QE) has been blamed for the rise of commodity prices worldwide, the equity market’s take off, worldwide inflation especially in lower income countries, dollar value decline, and rising domestic inflation. Perhaps it will eventually cause the ultimate in a misery index, stagflation.

But how does the money get from the Fed to the various markets? In all the theories I have read about, nobody has an answer. However, it might be found in the monetary transmission mechanism Ben Bernanke wrote about in his 1995 paper Inside the Black Box: The Credit Channel of Monetary Policy Transmission.

Less formally we could say that QE transfers money from a commercial bank to either highly volatile assets like commodities and stocks or to simply speculative instruments like futures and derivatives. We do know that the first transfer is that the Fed purchases long-term financial instruments especially government bonds. But then what happens? Do the bankers hand it over to their cousin Vinny to go bet at the Merc? That seems highly unlikely.

Even if there is more good news as bank lending continues to rise, it still takes a leap to believe that the monies are ending up in the hands of speculators or investors in the stock markets.


The fact that Commercial and Industrial Loans are increasing at an 8.6 annualized rate is certainly good news for the economy overall. The important question here is where does the money go after the Fed exchanges cash/money for the government bonds? The last phase of quantitative easing dubbed QE2 started in the later part of 2010 and was officially announced in the early part of November.

Graph: Excess Reserves of Depository Institutions (EXCRESNS):

The above graph certainly shows a huge increase in reserves since QE2 started and it’s in the same magnitude of the total amount of QE2 (around $600 billion). However, since QE1 started in late 2008, let’s look at a graph that covers that time period.

It is likely that this graph doesn’t account for every dollar QE1 and QE2 put into the system, but the rise from nearly zero to over 1.4 Trillion of excess reserves covers the majority of the easing reported. So what are these reserves doing there if not lent out to prospective borrowers?

Interest Rate Paid on Excess Reserve Balances:

I honestly can not answer why the Fed is paying interest on excess reserve balances. This is an important consideration since the banks are exchanging one near zero interest instrument for another one called excess reserves but financed by the Fed. But it is clear that the excess reserves absorbed a large portion of the Quantitative Easing, and it is not a monetary transmission mechanism that is causing some markets to expand.

What Is the Transmission Mechanism Then?

The most logical transmission is not a transmission of monies but a simple change in expectations. If prices will rise in the future then selling in the future is a better option, and interest rates will need to rise accordingly now.

Commodities react almost instantaneously to new information and adapt accordingly. Cullen Roche, a blogger at Seeking Alpha, provides some cogent discussions about QE2 in his article “Fed Contributing Directly to Speculative Behavior.” He shows how the commodity prices spiked over the Fed Chief’s press conference. Even though he thinks that QE2 was mostly a flop, he states that “A QE3 Would Only Exacerbate Commodities Speculation, Further Curtailing Real GDP Growth.” He may have a point going forward, and his biggest complaint about QE2 was that it targeted the amount of transactions instead of an explicit interest rate target as normal monetary policy is pursued. In other words, long-term bond rates should have been targeted and the amount of transactions should have been ignored which would have signaled the markets more than specific transactions in the market.


While most of the recent events can be explained by rising corporate earnings or simply supply and demand, I can not help to think that some of the Inflationistas and Hyperinflationistas took their own advice by buying up commodities and investing more in equity markets. The investments in the stock markets is overall a good thing. Commodities might be pushed higher from this frenzied buying, which could in fact create the necessary political will to reduce the structural rigidity this blog has been talking about. And sure enough, with gas costs high, Obama is going to speed oil production.

GARP for Regional Banks

With all the excess reserves in the banking system, this should indicate to an investor possibilities that banks may be the next growth sector. Hopefully using these excess reserves for more productive uses should increase their gross income and net income significantly. Of course any long-term economic growth will require a financially stable banking system. Most long-term recessions/depressions either start in the banking system or through contagion effects significantly damage the banking system profits.

Using a GARP (Growth at a Reasonble Price) filter at Sabrient Systems, I compiled a list of financial stocks and then selected all the banking industry stocks -- which happen to be all regional banks. The graph below shows the ratings by Sabrient along with their scores for Value, Growth and Momentum.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.