Does Quantitative Easing boost "liquidity" in "the market", that is then used to purchase other assets, which inflates those assets' prices?
That seems to be the conventional "wisdom".
But, as per Mark Twain:
“What gets us into trouble is not what we don't know.
It's what we know for sure that just ain't so.”
It's what we know for sure that just ain't so.”
One can certainly make the case that QE represses interest rates (of the tenors of the bonds purchased by the central bank) by introducing a new buyer into the market for those bonds, increasing the prices of those bonds at the margin. (But one can also make the case, as I have before, that the hope (on the part of Treasury market participants) that QE will be effective can cause interest rates to rise due to optimism about improved economic prospects, just like a good economic data announcement can do).
Regardless, assuming QE does cause rates to fall, one can certainly also make the case that lower interest rates on risk-free assets can encourage additional risk-seeking investment behaviour by investors seeking to increase their returns above those provided by low interest rates on government debt.
But, the argument has certainly also been made that QE "injects liquidity" into "the markets", which then fuels asset prices via direct channels, i.e. by the excess reserves the central bank has thus created then being used to purchase other assets.
This post is intended to provide references that offer context and information that contest that claim.
[sidenote: If Bank A owns $10 million of 10-yr Treasury notes that the central bank then purchases via QE in exchange for $10 million of reserve balances; can Bank A then sell those reserve balances to buy, say, corporate bonds instead? well, no; a bank cannot just "sell" its reserve balances; but even if that were possible, what would have happened to those reserve balances? did they go away? (no) --- they just exchanged hands. Bank A might now own a corporate bond instead of reserve balances but Bank Z now owns reserve balances instead of a corporate bond.... how exactly has liquidity thus been added to the system that has supposedly been used to purchase other financial assets?? furthermore, if the argument being made by some is that the Fed's injection via QE of "liquidity" (i.e. higher reserve balances) has been used to purchase other financial assets, then why are those reserve balances so high still? clearly those reserves still exist.. they haven't been retired (nor can they be, except by the central bank) ... so, at best they may have exchanged hands, from one bank to another, but in aggregate, they exist within the banking system, so how then have they fueled extras purchases of other financial assets??]
Central banks exchange non or low interest bearing assets - reserve balances - for longer term higher yielding securities.
Since lending is in no case ‘reserve constrained’, the ‘extra’ reserves do nothing for lending.
The purchase of the longer dated securities results in lower longer term rates than otherwise. The lower borrowing rates may or may not alter aggregate demand. The lower rates for savers definitely lowers aggregate demand.
Some readers have written to me asking to explain what quantitative easing is. Some of them had heard an ABC 7.30 Report segment the other night which interviewed the Bank of England Governor who outlined the BOE’s plan to “print billions of pounds” as its latest strategy to stimulate lending and hence economic activity in the very dismally performing UK economy. Once again we need to de-brief and learn what quantititative easing actually is. We need to understand that it is not a very good strategy for a sovereign government to follow in times of depressed demand and rising unemployment. We also need to get this “printing money” mantra out of our heads.
What is quantitative easing?
With very tight credit markets at present (that is, banks have upped their lending standards and made it harder for firms and households to access credit), central banks have started talking about using what is called quantitative easing to free up credit flowing especially as short-term interest rates fall towards zero. In fact, near zero interest rates are required if the central bank is to engage in quantitative easing!
Quantitative easing merely involves the central bank buying bonds (or other bank assets) in exchange for deposits made by the central bank in the commercial banking system – that is, crediting their reserve accounts. The aim is to create excess reserves which will then be loaned to chase a positive rate of return. So the central bank exchanges non- or low interest-bearing assets (which we might simply think of as reserve balances in the commercial banks) for higher yielding and longer term assets (securities).
So quantitative easing is really just an accounting adjustment in the various accounts to reflect the asset exchange. The commercial banks get a new deposit (central bank funds) and they reduce their holdings of the asset they sell.
Proponents of quantitative easing claim it adds liquidity to a system where lending by commercial banks is seemingly frozen because of a lack of reserves in the banking system overall. It is commonly claimed that it involves “printing money” to ease a “cash-starved” system. That is an unfortunate and misleading representation.
Invoking the “evil-sounding” printing money terminology to describe this practice is thus very misleading – and probably deliberately so. All transactions between the Government sector (Treasury and Central Bank) and the non-government sector involve the creation and destruction of net financial assets denominated in the currency of issue. Typically, when the Government buys something from the Non-government sector they just credit a bank account somewhere – that is, numbers denoting the size of the transaction appear electronically in the banking system.
It is inappropriate to call this process – “printing money”. Commentators who use this nomenclature do so because they know it sounds bad! The orthodox (neo-liberal) economics approach uses the “printing money” term as equivalent to “inflationary expansion”. If they understood how the modern monetary system actually worked they would never be so crass.
Crucially, quantitative easing requires the short-term interest rate to be at zero or close to it. Otherwise, the central bank would not be able to maintain control of a positive interest rate target because the excess reserves would invoke a competitive process in the interbank market which would effectively drive the interest rate down.
The Bank of England has now cut short-term interest rates to virtually zero (the lowest since the BOE was formed in 1694) in the misguided belief that monetary policy could solve the demand failure they are facing. While still eschewing fiscal policy (spending and taxation) they now have nowhere to go with monetary policy unless they begin to engage in quantitative easing. As a consequence, over the next three months they intend to spend £150bn buying assets from the private sector called gilts (which are just government bonds) and also high quality corporate debt.
The aim is to increase liquidity in the credit markets and encourage banks to increase lending to companies as explained above.
Does quantitative easing work? The mainstream belief is that quantitative easing will stimulate the economy sufficiently to put a brake on the downward spiral of lost production and the increasing unemployment.
It is based on the erroneous belief that the banks need reserves before they can lend and that quantititative easing provides those reserves. That is a major misrepresentation of the way the banking system actually operates. But the mainstream position asserts (wrongly) that banks only lend if they have prior reserves. The illusion is that a bank is an institution that accepts deposits to build up reserves and then on-lends them at a margin to make money. The conceptualisation suggests that if it doesn’t have adequate reserves then it cannot lend. So the presupposition is that by adding to bank reserves, quantitative easing will help lending.
But this is a completely incorrect depiction of how banks operate. Bank lending is not “reserve constrained”. Banks lend to any credit worthy customer they can find and then worry about their reserve positions afterwards. If they are short of reserves (their reserve accounts have to be in positive balance each day and in some countries central banks require certain ratios to be maintained) then they borrow from each other in the interbank market or, ultimately, they will borrow from the central bank through the so-called discount window. They are reluctant to use the latter facility because it carries a penalty (higher interest cost).
The point is that building bank reserves will not increase the bank’s capacity to lend. Loans create deposits which generate reserves.
The reason that the commercial banks are currently not lending much is because they are not convinced there are credit worthy customers on their doorstep. In the current climate the assessment of what is credit worthy has become very strict compared to the lax days as the top of the boom approached.
The major formal constraints on bank lending (other than a stream of credit worthy customers) are expressed in the capital adequacy requirements set by the Bank of International Settlements (BIS) which is the central bank to the central bankers. They relate to asset quality and required capital that the banks must hold. These requirements manifest in the lending rates that the banks charge customers. Bank lending is never constrained by lack of reserves.
While some point to the quantititative easing experience in Japan between 2001 and 2006, the reality is that it was highly expansionary fiscal policy not the monetary policy gymnastics which kept that economy from deflating and allowed it to return to stronger growth in recent years (until the crisis hit).
We should be absolutely clear on what the BOE is doing. It is buying one type of financial asset (private holdings of bonds, company paper) and exchanging it for another (reserve balances at the BOE). The net financial assets in the private sector are in fact unchanged although the portfolio composition of those assets is altered (maturity substitution) which changes yields and returns.
In terms of changing portfolio compositions, quantitative easing increases central bank demand for “long maturity” assets held in the private sector which reduces interest rates at the longer end of the yield curve. These are traditionally thought of as the investment rates. This might increase aggregate demand given the cost of investment funds is likely to drop. But on the other hand, the lower rates reduce the interest-income of savers who will reduce consumption (demand) accordingly.
How these opposing effects balance out is unclear. The central banks certainly don’t know! Overall, this uncertainty points to the problems involved in using monetary policy to stimulate (or contract) the economy. It is a blunt policy instrument with ambiguous impacts.
The major problem facing the economy at present is that there is not a willingness to spend by the private sector and the resulting spending gap, has to, initially, be filled by the government using its fiscal policy capacity. I prefer direct public sector job creation to be the principal fiscal vehicle. But fiscal policy it has to be. Then when the negative sentiment is turned around, private borrowing will recommence and investment spending will grow again. Then the economy moves forward some more and the budget deficit falls.
So I don’t think quantitative easing is a sensible anti-recession strategy. The fact that governments are using it now just reflects the neo-liberal bias towards monetary policy over fiscal policy. What will motivate consumers to borrow if they are scared of losing their jobs? Why would a company borrow if they expect their sales to be depressed? The problem is a failure of demand which has to be addressed via demand measures – that is, fiscal policy. Overall, you can only take a horse to water ….!
There are also those that claim that quantitative easing will expose the economy to uncontrollable inflation. This is just harking back to the old and flawed Monetarist doctrine based on the so-called Quantity Theory of Money. This theory has no application in a modern monetary economy and proponents of it have to explain why economies with huge excess capacity to produce (idle capital and high proportions of unused labour) cannot expand production when the orders for goods and services increase. Should quantititative easing actually stimulate spending then the depressed economies will likely respond by increasing output not prices.
The Basics of Banking. Cullen Roche.
The monetary system is designed to cater to the creation of the public’s money supply, primarily by private banks by establishing a money supply that is elastic. That is, it can expand and contract as the demand for money expands and contracts. Most modern money takes the form of bank deposits, and most market exchanges involving private agents are transacted in private bank money. As I have discussed, inside money governs the day-to-day functioning of modern fiat monetary systems. The role of outside money, which is created by the public sector, is comparatively minor and plays a mostly facilitating role (see here for a more thorough explanation on the difference between inside money and outside money).¹
Like the government, banks are also money issuers but not issuers of private sector net financial assets. That is, banking transactions always involve the creation of a private sector asset and a liability. Banks create loans independent of government constraint (aside from the regulatory framework). As I will explain, banks make loans independent of their reserve position with the government, rendering the traditional money multiplier deeply flawed.
The monetary system in the developed world is designed specifically around a competitive private banking system. The banking system is not a public-private partnership serving public purpose, as the central bank essentially is. The banking system is a privately owned component of the system run for private profit. The thinking behind this design was to disperse the power of money creation away from a centralized government and put it into the hands of nongovernment entities. The government’s relationship with the private banking system is more a support mechanism than anything else. In this regard I like to think of the government as being a facilitator in helping to sustain a viable credit-based money system.
It’s important to understand that banks are not constrained by the government (outside the regulatory framework) in terms of how they create money. Business schools teach that banks obtain deposits and then leverage those deposits ten times or so. This is why we call the modern banking system a fractional reserve banking system. Banks supposedly lend a portion of their reserves. There’s just one problem here: banks are never reserve constrained. Banks are always capital constrained. This can best be seen in countries such as Canada, which has no reserve requirements. Reserves are used for two purposes—to settle payments in the interbank market and to meet the Fed’s reserve requirements. Aside from this, reserves have little impact on the day-to-day lending operations of banks in the United States. This was recently confirmed in a paper from the Federal Reserve:
The concept of “reserves” sometimes confuses people, but reserves can be thought of as the bank deposits for banks. If we think of the banking system that we use then our deposits are primarily created by banks when they make new loans. But the banking system also has a banking system – the Federal Reserve system. And every bank must maintain an account with the Federal Reserve. This is the market where banks settle interbank payments (payments across different banks). You can think of the reserve system as a big clearinghouse for all the banks to settle payments with. This is always done in reserve deposits so banks are required to maintain a certain amount of reserves at all times. But we shouldn’t think of this clearinghouse as the center of the monetary system or even the point where loans are “multiplied”. That is, the fact that banks must maintain some level of reserves does not mean that they are constrained in their loan making by the quantity of reserves they hold.
That banks are not reserve constrained can mean only one thing—banks lend when credit-worthy customers have demand for loans (assuming the banking system is healthy and banks are engaging in the business they are designed to transact). Loans create deposits, not vice versa. In the loan creation process banks will make loans first (resulting in new deposits) and will find necessary reserves after the fact (either in the overnight market or through the Federal Reserve).
Understanding the business of banking is rather simple. It’s best to think of banks as running a payments system that helps us all transact within the economy. In addition to helping manage this payments system, banks issue money in the form of loans. Banks earn a profit from transacting business when their assets are less expensive than their liabilities. In other words banks need to run this payments system smoothly but will seek to do so in a manner that doesn’t reduce their profitability.
Banks don’t necessarily use their deposits or reserves to create loans, however. Banks make loans and find reserves after the fact if they have to. But since banking is a spread business (having assets that are less expensive than liabilities), the banks will always seek the least expensive source of funds for managing their payment system. That just so happens to be bank deposits. This gives the appearance that banks fund their loan book by obtaining deposits, but this is not necessarily the case. It is better to think of banking as a spread business in which the bank simply acquires the least expensive liabilities to sustain its payment system and maximize profits. Banks need funding sources to run their businesses, but they do not necessarily need reserves or deposits to make those loans.
To illustrate this point I will briefly review the change in balance sheet composition between banks and households before and after a loan is made. Since banks are not constrained by their reserves, the banks do not need to have X amount of reserves on hand to create new loans. But banks must have ample capital to be able to operate and meet regulatory requirements.
I’ll start with a simple money system shown in Figure 7.4. In this example banks begin with $120 in assets and liabilities comprised of currency, reserves, equity, and deposits. Of this, households hold $80 in deposits, which are assets for the households and liabilities for the banking system. That is, the bank owes you your deposit on demand.
This banking system has reserves already, but this is not necessary for the bank to issue a loan. It must simply remain solvent within its regulatory requirements. But if the households want to take out a new loan to purchase a new home for $50, the bank simply credits the household’s account, as Figure 7.5 shows. When the new loan is made, household deposits increase to $130. Household loans increase by $50. Bank assets increase by $50 (the loan), and bank liabilities increase by $50 (the deposit).
If the bank needs reserves to help settle payments or meet reserve requirements, it can always borrow from another bank in the interbank market, or, if it must, it can borrow from the Federal Reserve Discount Window. The key lesson here is to understand that money in the modern monetary system is largely endogenous and exists through the creation of the loan process within the private sector. The central bank and reserves play a far smaller role in the broad money supply than is often perceived. Perhaps most important, this example shows that understanding endogenous money means we need to rethink how we teach banking and apply it to our understandings of the monetary machine. Banks and money are much more important than most modern economic models imply.
The other day, Ben Bernanke explained that he is not adding any new cash to the system via QE:
From the standpoint of prospective investment returns, it is important to recognize that the main effect of quantitative easing has been to suppress the expected return on virtually all classes of investment to unusually weak levels. It's widely believed that somehow, QE2 has created all sorts of liquidity that is "sloshing" around the economy and "trying to find a home" in stocks, commodities, and other investments. But this is not how equilibrium works.
Here's how equilibrium does work. Every security that is issued has to be held by someone, in precisely the form in which it was created, until that security is retired. Period. That means that if the Fed creates $2.4 trillion in currency and bank reserves, somebody has to hold that money, in that form, until those liabilities are retired. The money ultimately can't go anywhere. If someone tries to get rid of their cash in order to buy stock, somebody else has to give up the stock and hold the cash. In the end, every share of stock that has been issued has to be held by somebody. Every money market security that has been issued has to be held by somebody. Every dollar bill that has been created has to be held by somebody. None of these instruments somehow "find a home" by going somewhere else or becoming something else. They are home.
Let me be clear - the additional monetary base created by the Fed certainly is "liquidity" from the standpoint of the banking system, ... The point, however, is that it is incoherent to say that this "cash on the sidelines" will somehow find a home in some other financial market, or anywhere else in a manner that makes it vanish from "the sidelines" - until it is explicitly retired by the Fed.
So what is the effect of creating an extra $600 billion dollars of monetary base by having the Fed purchase $600 billion dollars of Treasury debt? The same thing that happens anytime any security is issued. Somebody has to hold it, and the returns on all other assets have to shift by just enough to make everyone in the economy happy, at the margin, to hold the outstanding quantity of all of the securities that have been issued. In practice, the only way you can get people to willingly hold $2.4 trillion in non-interest bearing cash is to depress the return on all close substitutes to next to zero. So short-term Treasury bill yields have been pressed to nearly nothing.
Of course, people also look at risky assets and ask whether they might be able to get higher risk-adjusted returns by holding those instead. In order to make people happy to hold the outstanding quantity of zero return cash, the prospective returns on other risky securities have also collapsed (securities are a claim to future cash flows - as investors pay a higher price, they implicitly agree to accept a lower long-term return). In my view, this has gone on to an extent far beyond what is likely to be sustained, ..... If investors don't understand that this is how QE2 is "working," they are likely to be as blindsided by the coming decade of weak investment returns as they've been over the past decade.
Paul Sheard, Chief Global Economist at S&P (Aug 2013):
John Maynard Keynes famously wrote that: “Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.” (1) A modern example of that dictum, relevant to the economy, policy, and markets, is the widespread view that banks can “lend out” their reserves (deposits) at the central bank, as if bank reserves represented a pool of money that is just waiting to “flow into” bank lending. Because such a thing cannot occur and therefore has not occurred, the point is usually made in reverse: banks currently are not “lending out” their reserves–rather they are “parking” their reserves at the central bank or leaving them “idle.” But that they might lend them out in the future is a lurking risk and a reason to be cautious about the central bank engaging in aggressive quantitative easing (QE).
Many talk as if banks can “lend out” their reserves, raising concerns that massive excess reserves created by QE could fuel runaway credit creation and inflation in the future. But banks cannot lend their reserves directly to commercial borrowers, so this concern is misplaced.
• Banks do need to hold reserves (as a liquidity buffer) against their deposits, and banks create deposits when they lend. But normally banks are not reserve constrained, so excess reserves do not loosen a reserve constraint.
• Banks in aggregate can reduce their reserves only to the extent that they initiate new lending and the bank deposits created as a result flow into the economy as new banknotes as the public demands more of them.
• QE does aim to ease financial conditions and spur more bank lending than otherwise would have occurred, but the mechanisms by which this happens are much more subtle and indirect than commonly implied.
• If the excess reserves created by QE were to be associated with too much credit creation, central banks could readily extinguish them.
Quantitative easing 101. Bill Mitchell. March 13, 2009.
Some readers have written to me asking to explain what quantitative easing is. Some of them had heard an ABC 7.30 Report segment the other night which interviewed the Bank of England Governor who outlined the BOE’s plan to “print billions of pounds” as its latest strategy to stimulate lending and hence economic activity in the very dismally performing UK economy. Once again we need to de-brief and learn what quantititative easing actually is. We need to understand that it is not a very good strategy for a sovereign government to follow in times of depressed demand and rising unemployment. We also need to get this “printing money” mantra out of our heads.
What is quantitative easing?
With very tight credit markets at present (that is, banks have upped their lending standards and made it harder for firms and households to access credit), central banks have started talking about using what is called quantitative easing to free up credit flowing especially as short-term interest rates fall towards zero. In fact, near zero interest rates are required if the central bank is to engage in quantitative easing!
Quantitative easing merely involves the central bank buying bonds (or other bank assets) in exchange for deposits made by the central bank in the commercial banking system – that is, crediting their reserve accounts. The aim is to create excess reserves which will then be loaned to chase a positive rate of return. So the central bank exchanges non- or low interest-bearing assets (which we might simply think of as reserve balances in the commercial banks) for higher yielding and longer term assets (securities).
So quantitative easing is really just an accounting adjustment in the various accounts to reflect the asset exchange. The commercial banks get a new deposit (central bank funds) and they reduce their holdings of the asset they sell.
Proponents of quantitative easing claim it adds liquidity to a system where lending by commercial banks is seemingly frozen because of a lack of reserves in the banking system overall. It is commonly claimed that it involves “printing money” to ease a “cash-starved” system. That is an unfortunate and misleading representation.
Invoking the “evil-sounding” printing money terminology to describe this practice is thus very misleading – and probably deliberately so. All transactions between the Government sector (Treasury and Central Bank) and the non-government sector involve the creation and destruction of net financial assets denominated in the currency of issue. Typically, when the Government buys something from the Non-government sector they just credit a bank account somewhere – that is, numbers denoting the size of the transaction appear electronically in the banking system.
It is inappropriate to call this process – “printing money”. Commentators who use this nomenclature do so because they know it sounds bad! The orthodox (neo-liberal) economics approach uses the “printing money” term as equivalent to “inflationary expansion”. If they understood how the modern monetary system actually worked they would never be so crass.
Crucially, quantitative easing requires the short-term interest rate to be at zero or close to it. Otherwise, the central bank would not be able to maintain control of a positive interest rate target because the excess reserves would invoke a competitive process in the interbank market which would effectively drive the interest rate down.
The Bank of England has now cut short-term interest rates to virtually zero (the lowest since the BOE was formed in 1694) in the misguided belief that monetary policy could solve the demand failure they are facing. While still eschewing fiscal policy (spending and taxation) they now have nowhere to go with monetary policy unless they begin to engage in quantitative easing. As a consequence, over the next three months they intend to spend £150bn buying assets from the private sector called gilts (which are just government bonds) and also high quality corporate debt.
The aim is to increase liquidity in the credit markets and encourage banks to increase lending to companies as explained above.
Does quantitative easing work? The mainstream belief is that quantitative easing will stimulate the economy sufficiently to put a brake on the downward spiral of lost production and the increasing unemployment.
It is based on the erroneous belief that the banks need reserves before they can lend and that quantititative easing provides those reserves. That is a major misrepresentation of the way the banking system actually operates. But the mainstream position asserts (wrongly) that banks only lend if they have prior reserves. The illusion is that a bank is an institution that accepts deposits to build up reserves and then on-lends them at a margin to make money. The conceptualisation suggests that if it doesn’t have adequate reserves then it cannot lend. So the presupposition is that by adding to bank reserves, quantitative easing will help lending.
But this is a completely incorrect depiction of how banks operate. Bank lending is not “reserve constrained”. Banks lend to any credit worthy customer they can find and then worry about their reserve positions afterwards. If they are short of reserves (their reserve accounts have to be in positive balance each day and in some countries central banks require certain ratios to be maintained) then they borrow from each other in the interbank market or, ultimately, they will borrow from the central bank through the so-called discount window. They are reluctant to use the latter facility because it carries a penalty (higher interest cost).
The point is that building bank reserves will not increase the bank’s capacity to lend. Loans create deposits which generate reserves.
The reason that the commercial banks are currently not lending much is because they are not convinced there are credit worthy customers on their doorstep. In the current climate the assessment of what is credit worthy has become very strict compared to the lax days as the top of the boom approached.
The major formal constraints on bank lending (other than a stream of credit worthy customers) are expressed in the capital adequacy requirements set by the Bank of International Settlements (BIS) which is the central bank to the central bankers. They relate to asset quality and required capital that the banks must hold. These requirements manifest in the lending rates that the banks charge customers. Bank lending is never constrained by lack of reserves.
While some point to the quantititative easing experience in Japan between 2001 and 2006, the reality is that it was highly expansionary fiscal policy not the monetary policy gymnastics which kept that economy from deflating and allowed it to return to stronger growth in recent years (until the crisis hit).
We should be absolutely clear on what the BOE is doing. It is buying one type of financial asset (private holdings of bonds, company paper) and exchanging it for another (reserve balances at the BOE). The net financial assets in the private sector are in fact unchanged although the portfolio composition of those assets is altered (maturity substitution) which changes yields and returns.
In terms of changing portfolio compositions, quantitative easing increases central bank demand for “long maturity” assets held in the private sector which reduces interest rates at the longer end of the yield curve. These are traditionally thought of as the investment rates. This might increase aggregate demand given the cost of investment funds is likely to drop. But on the other hand, the lower rates reduce the interest-income of savers who will reduce consumption (demand) accordingly.
How these opposing effects balance out is unclear. The central banks certainly don’t know! Overall, this uncertainty points to the problems involved in using monetary policy to stimulate (or contract) the economy. It is a blunt policy instrument with ambiguous impacts.
The major problem facing the economy at present is that there is not a willingness to spend by the private sector and the resulting spending gap, has to, initially, be filled by the government using its fiscal policy capacity. I prefer direct public sector job creation to be the principal fiscal vehicle. But fiscal policy it has to be. Then when the negative sentiment is turned around, private borrowing will recommence and investment spending will grow again. Then the economy moves forward some more and the budget deficit falls.
So I don’t think quantitative easing is a sensible anti-recession strategy. The fact that governments are using it now just reflects the neo-liberal bias towards monetary policy over fiscal policy. What will motivate consumers to borrow if they are scared of losing their jobs? Why would a company borrow if they expect their sales to be depressed? The problem is a failure of demand which has to be addressed via demand measures – that is, fiscal policy. Overall, you can only take a horse to water ….!
There are also those that claim that quantitative easing will expose the economy to uncontrollable inflation. This is just harking back to the old and flawed Monetarist doctrine based on the so-called Quantity Theory of Money. This theory has no application in a modern monetary economy and proponents of it have to explain why economies with huge excess capacity to produce (idle capital and high proportions of unused labour) cannot expand production when the orders for goods and services increase. Should quantititative easing actually stimulate spending then the depressed economies will likely respond by increasing output not prices.
Claudio Borio, BIS, November, 2009.
"obliges the central bank to meet the small demand for (excess) reserves very precisely, in order to avoid unwarranted extreme volatility in the rate … But in order to induce banks to accept a large expansion of such balances in the context of balance sheet policy, the central bank has to make bank reserves sufficiently attractive relative to other assets … In effect, this renders them almost perfect substitutes with other short-term sovereign paper. This means paying an equivalent interest rate. In the process, their specialness is lost. Bank reserves become simply another claim issued by the public sector. It is distinguished from others primarily by having an overnight maturity and a narrower base of potential investors."
The monetary system is designed to cater to the creation of the public’s money supply, primarily by private banks by establishing a money supply that is elastic. That is, it can expand and contract as the demand for money expands and contracts. Most modern money takes the form of bank deposits, and most market exchanges involving private agents are transacted in private bank money. As I have discussed, inside money governs the day-to-day functioning of modern fiat monetary systems. The role of outside money, which is created by the public sector, is comparatively minor and plays a mostly facilitating role (see here for a more thorough explanation on the difference between inside money and outside money).¹
Like the government, banks are also money issuers but not issuers of private sector net financial assets. That is, banking transactions always involve the creation of a private sector asset and a liability. Banks create loans independent of government constraint (aside from the regulatory framework). As I will explain, banks make loans independent of their reserve position with the government, rendering the traditional money multiplier deeply flawed.
The monetary system in the developed world is designed specifically around a competitive private banking system. The banking system is not a public-private partnership serving public purpose, as the central bank essentially is. The banking system is a privately owned component of the system run for private profit. The thinking behind this design was to disperse the power of money creation away from a centralized government and put it into the hands of nongovernment entities. The government’s relationship with the private banking system is more a support mechanism than anything else. In this regard I like to think of the government as being a facilitator in helping to sustain a viable credit-based money system.
It’s important to understand that banks are not constrained by the government (outside the regulatory framework) in terms of how they create money. Business schools teach that banks obtain deposits and then leverage those deposits ten times or so. This is why we call the modern banking system a fractional reserve banking system. Banks supposedly lend a portion of their reserves. There’s just one problem here: banks are never reserve constrained. Banks are always capital constrained. This can best be seen in countries such as Canada, which has no reserve requirements. Reserves are used for two purposes—to settle payments in the interbank market and to meet the Fed’s reserve requirements. Aside from this, reserves have little impact on the day-to-day lending operations of banks in the United States. This was recently confirmed in a paper from the Federal Reserve:
Changes in reserves are unrelated to changes in lending, and open market operations do not have a direct impact on lending. We conclude that the textbook treatment of money in the transmission mechanism can be rejected.This is an important point because many people have assumed that various Fed policies in recent years (such as quantitative easing) would be inflationary or even hyperinflationary based on the flawed concept that an expansion of the monetary base (reserves) would lead directly to bank lending and higher inflation. Because banks are not reserve constrained, that is, they don’t lend their reserves or multiply their reserves, this doesn’t necessarily lead to more lending and will not result in the private sector’s being able to access more capital.
The concept of “reserves” sometimes confuses people, but reserves can be thought of as the bank deposits for banks. If we think of the banking system that we use then our deposits are primarily created by banks when they make new loans. But the banking system also has a banking system – the Federal Reserve system. And every bank must maintain an account with the Federal Reserve. This is the market where banks settle interbank payments (payments across different banks). You can think of the reserve system as a big clearinghouse for all the banks to settle payments with. This is always done in reserve deposits so banks are required to maintain a certain amount of reserves at all times. But we shouldn’t think of this clearinghouse as the center of the monetary system or even the point where loans are “multiplied”. That is, the fact that banks must maintain some level of reserves does not mean that they are constrained in their loan making by the quantity of reserves they hold.
That banks are not reserve constrained can mean only one thing—banks lend when credit-worthy customers have demand for loans (assuming the banking system is healthy and banks are engaging in the business they are designed to transact). Loans create deposits, not vice versa. In the loan creation process banks will make loans first (resulting in new deposits) and will find necessary reserves after the fact (either in the overnight market or through the Federal Reserve).
Understanding the business of banking is rather simple. It’s best to think of banks as running a payments system that helps us all transact within the economy. In addition to helping manage this payments system, banks issue money in the form of loans. Banks earn a profit from transacting business when their assets are less expensive than their liabilities. In other words banks need to run this payments system smoothly but will seek to do so in a manner that doesn’t reduce their profitability.
Banks don’t necessarily use their deposits or reserves to create loans, however. Banks make loans and find reserves after the fact if they have to. But since banking is a spread business (having assets that are less expensive than liabilities), the banks will always seek the least expensive source of funds for managing their payment system. That just so happens to be bank deposits. This gives the appearance that banks fund their loan book by obtaining deposits, but this is not necessarily the case. It is better to think of banking as a spread business in which the bank simply acquires the least expensive liabilities to sustain its payment system and maximize profits. Banks need funding sources to run their businesses, but they do not necessarily need reserves or deposits to make those loans.
To illustrate this point I will briefly review the change in balance sheet composition between banks and households before and after a loan is made. Since banks are not constrained by their reserves, the banks do not need to have X amount of reserves on hand to create new loans. But banks must have ample capital to be able to operate and meet regulatory requirements.
I’ll start with a simple money system shown in Figure 7.4. In this example banks begin with $120 in assets and liabilities comprised of currency, reserves, equity, and deposits. Of this, households hold $80 in deposits, which are assets for the households and liabilities for the banking system. That is, the bank owes you your deposit on demand.
This banking system has reserves already, but this is not necessary for the bank to issue a loan. It must simply remain solvent within its regulatory requirements. But if the households want to take out a new loan to purchase a new home for $50, the bank simply credits the household’s account, as Figure 7.5 shows. When the new loan is made, household deposits increase to $130. Household loans increase by $50. Bank assets increase by $50 (the loan), and bank liabilities increase by $50 (the deposit).
If the bank needs reserves to help settle payments or meet reserve requirements, it can always borrow from another bank in the interbank market, or, if it must, it can borrow from the Federal Reserve Discount Window. The key lesson here is to understand that money in the modern monetary system is largely endogenous and exists through the creation of the loan process within the private sector. The central bank and reserves play a far smaller role in the broad money supply than is often perceived. Perhaps most important, this example shows that understanding endogenous money means we need to rethink how we teach banking and apply it to our understandings of the monetary machine. Banks and money are much more important than most modern economic models imply.
What Are Bank Reserves? Cullen Roche. Oct. 6, 2010.
Bank reserves can be a confusing topic for anyone who doesn’t have banking and finance experience. In this piece I will explain what reserves are, why they exist and what their role is in the financial system.
Central Bank reserves are deposits on reserve at the Central Bank. In the case of the USA reserves are issued by the Federal Reserve. This is often confusing for the average person who will likely never process a payment with reserves. This is because the reserve system is really just a payment system for the banks. So you can think of the banking system as being two tiered. There is the deposit system we all use. And the reserve system is a banking system that the banks all use with accounts at the Federal Reserve.
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Since the reserve system is essentially imposed on the banking system you can think of all reserves as being “required”. That is, some quantity of reserves is necessary for payments to settle everyday. Central Banks typically set a quantity of “required reserves” and any excess quantity above that is called “excess reserves”. In today’s system there are quite a bit of excess reserves because Central Banks have expanded their balance sheets to buy bonds in policies like Quantitative Easing. But it’s best to think of all reserves as being required since they are issued by Central Banks and the quantity of reserves is essentially imposed on the banking sector.
It’s important to note that the existence of the reserve system is primarily for the purpose of settling interbank payments and smoothing the settlement of transactions. This is particularly important during times of panic when the private interbank markets would sometimes seize up. By having this system under public control the system is unlikely to fail when it is most needed because the Federal Reserve does not need to operate at a profit to remain solvent. This significantly reduces the instability in the banking system by ensuring that banks can always be confident when processing payments among one another.
Reserves also play an important role in helping the Central Bank transact monetary policy. Since the Federal Reserve has a mandate of ensuring full employment and price stability they will attempt to influence the financial system to optimize these conditions. In the process of doing this they will alter interest rates and the quantity of reserves in efforts to stimulate or slow the economy. At present these operations include Quantitative Easing and the payment of interest on excess reserves. QE is a process by which the Central Bank expands its balance sheet thereby increasing the quantity of reserves in the financial system in order to influence interest rates and private portfolios
In normal times the Federal Reserve would influence interest rates by altering the quantity of reserves in the interbank market. Banks try to lend their reserves to banks with a shortfall thereby maximizing profits, but since this is a closed system the banks can never get rid of their reserves in the aggregate.
Understanding the Mechanics of a QE Transaction. Cullen Roche. Nov. 9, 2010.
Some people want you to believe that the Fed just injected the economy and stock market full of money that will now result in an economic boom and much higher prices in most assets. That’s simply not true. Here’s the actual mechanics behind QE.
Before we begin, it’s important that investors understand exactly what “cash” is. “Cash” is simply a very liquid liability of the U.S. government. You can call it “cash”, Federal Reserve notes, whatever. But it is a liability of the U.S. government. Just like a 13 week treasury bill. What is the major distinction between “cash” and bills? Just the duration and amount of interest the two pay. Think of one like a checking account and the other like a savings account.
This is a crucial point that I think a lot of us are having trouble wrapping our heads around. In school we are taught that “cash” is its own unique asset class. But that’s not really true. “Cash” as it sits in your bank account is really just a very very liquid government liability. What is the difference between your checking and savings account? Do you classify them both as “cash”? Do you consider your savings accounts a slightly less liquid interest bearing form of the same thing a checking account is?
What is a treasury note account? It is a savings account with the government. So now you have to ask yourself why you think cash is so much different than a treasury note? What is the difference between your ETrade cash earning 0.1% and that t note earning 0.2%? NOTHING except the interest rate and the duration. You can’t use your 13 week bill to pay your taxes tomorrow, but that doesn’t mean it isn’t a slightly less liquid form of the exact same thing that we all refer to as “cash”. They are both govt liabilities and assets of yours.
When you own a t note you really just traded your “cash” for a slightly less liquid form of the same exact thing. If the Fed buys those t notes from you they give you back your cash minus the interest rate. That’s all there is to it. No change in the money supply. No change in anything except the rate of interest you were earning. If the government removes t notes then all they’re doing is altering the term structure of their liabilities. They’re not changing the AMOUNT of liabilities.
“Now, what these reserves are is essentially deposits that commercial banks hold with the Fed, so sometimes you hear the Fed is printing money, that’s not really happening, the amount of cash in circulation is not changing. What’s happening is that banks are holding more and more reserves with the Fed.”This is very important because millions of investors are betting on the inflationary impact of QE. But again, as Mr. Bernanke said there is no reason to believe that QE is inflationary. Why? Because they are not adding net new financial assets to the private sector. The assets already existed! They are merely swapping reserves for bonds. They are giving the banks a checking account instead of a savings account.
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The Fed has caused this mass hysteria over a minor interest rate decline. In short, there is not more cash in the system following QE. There is not more “firepower” with which to purchase equities. Hopefully, the above description makes that very clear.
Cash and Credit - Implications for the Financial Markets. John P. Hussman. Feb. 28, 2011.
Here's how equilibrium does work. Every security that is issued has to be held by someone, in precisely the form in which it was created, until that security is retired. Period. That means that if the Fed creates $2.4 trillion in currency and bank reserves, somebody has to hold that money, in that form, until those liabilities are retired. The money ultimately can't go anywhere. If someone tries to get rid of their cash in order to buy stock, somebody else has to give up the stock and hold the cash. In the end, every share of stock that has been issued has to be held by somebody. Every money market security that has been issued has to be held by somebody. Every dollar bill that has been created has to be held by somebody. None of these instruments somehow "find a home" by going somewhere else or becoming something else. They are home.
Let me be clear - the additional monetary base created by the Fed certainly is "liquidity" from the standpoint of the banking system, ... The point, however, is that it is incoherent to say that this "cash on the sidelines" will somehow find a home in some other financial market, or anywhere else in a manner that makes it vanish from "the sidelines" - until it is explicitly retired by the Fed.
So what is the effect of creating an extra $600 billion dollars of monetary base by having the Fed purchase $600 billion dollars of Treasury debt? The same thing that happens anytime any security is issued. Somebody has to hold it, and the returns on all other assets have to shift by just enough to make everyone in the economy happy, at the margin, to hold the outstanding quantity of all of the securities that have been issued. In practice, the only way you can get people to willingly hold $2.4 trillion in non-interest bearing cash is to depress the return on all close substitutes to next to zero. So short-term Treasury bill yields have been pressed to nearly nothing.
Of course, people also look at risky assets and ask whether they might be able to get higher risk-adjusted returns by holding those instead. In order to make people happy to hold the outstanding quantity of zero return cash, the prospective returns on other risky securities have also collapsed (securities are a claim to future cash flows - as investors pay a higher price, they implicitly agree to accept a lower long-term return). In my view, this has gone on to an extent far beyond what is likely to be sustained, ..... If investors don't understand that this is how QE2 is "working," they are likely to be as blindsided by the coming decade of weak investment returns as they've been over the past decade.
Paul Sheard, Chief Global Economist at S&P (Aug 2013):
John Maynard Keynes famously wrote that: “Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.” (1) A modern example of that dictum, relevant to the economy, policy, and markets, is the widespread view that banks can “lend out” their reserves (deposits) at the central bank, as if bank reserves represented a pool of money that is just waiting to “flow into” bank lending. Because such a thing cannot occur and therefore has not occurred, the point is usually made in reverse: banks currently are not “lending out” their reserves–rather they are “parking” their reserves at the central bank or leaving them “idle.” But that they might lend them out in the future is a lurking risk and a reason to be cautious about the central bank engaging in aggressive quantitative easing (QE).
Many talk as if banks can “lend out” their reserves, raising concerns that massive excess reserves created by QE could fuel runaway credit creation and inflation in the future. But banks cannot lend their reserves directly to commercial borrowers, so this concern is misplaced.
• Banks do need to hold reserves (as a liquidity buffer) against their deposits, and banks create deposits when they lend. But normally banks are not reserve constrained, so excess reserves do not loosen a reserve constraint.
• Banks in aggregate can reduce their reserves only to the extent that they initiate new lending and the bank deposits created as a result flow into the economy as new banknotes as the public demands more of them.
• QE does aim to ease financial conditions and spur more bank lending than otherwise would have occurred, but the mechanisms by which this happens are much more subtle and indirect than commonly implied.
• If the excess reserves created by QE were to be associated with too much credit creation, central banks could readily extinguish them.
Banks Don't Lend Out Reserves. Frances Coppola. Jan. 21, 2014.
This post by Sober Look caught my eye. It has a lovely chart which shows the considerable shortfall of lending relative to deposits in American banks:
This doesn't look too good, does it? Why on earth aren't banks lending? After all, it seems they have the money to do so. So what is stopping them?
Firstly, here’s a short explanation of bank lending. Under normal circumstances, deposits and loans are more-or-less equal across the banking system as a whole. This is because when a bank creates a new loan, it also creates a new balancing deposit. It creates this "from thin air", not from existing money: banks do not "lend out" existing deposits, as is commonly thought. You can see this clearly on the chart. Until 2009, deposits and loans were roughly equal.
But since 2009 there has been a very evident change. There is a large and growing gap between loans and deposits. So what is causing this?
Firstly, banks, households and businesses have been deleveraging. That means they are paying off (or writing off) loans and not taking on any more. Damaged banks don't want to lend, damaged households don't want to borrow and fearful businesses don't want to invest. The combination of these three factors means that both the supply and the demand for loans are considerably below the levels prior to the financial crisis. This explains the evident fall in loan creation (red line) in 2009. Though the line is now rising. Seems banks are lending, actually, though not at the rate they were before the crisis.
Secondly, the Fed has been doing QE. QE involves buying assets held by the private sector, both banks and investors. When the Fed buys from banks, the bank simply exchanges one asset (UST or MBS) for another (new reserves), and there is no change in deposits. But when the Fed buys assets from private sector investors, the purchases are intermediated through banks, and the newly-created dollars that investors receive in return for their assets are credited to their bank deposit accounts. Consequently bank deposits rise. This is the reason why the blue and red lines have diverged. Without QE, the two would have remained in sync: we would have seen a fall in both loans and deposits, since money is destroyed when loans are paid off or written off.
But, what about all those reserves on which the Fed is paying interest? Surely this is a major reason why bank lending is so far below deposit creation? After all, if banks can be paid interest on risk-free deposits at the Fed, they won't want to lend, will they?
This chart appears to support that argument. Sober Look has "added back" to the loan line the excess reserves held by banks at the Fed:
Well, that's amazing. Loans + excess reserves = deposits. Therefore placing excess reserves at the Fed must be crowding out lending, mustn't it? So what we need to do is cut the interest rate on excess reserves, preferably into negative territory. Then banks will be forced to lend out the money.
No, just no. Double entry accounting is sufficient to explain this effect. It tells us absolutely nothing about the lending behavior of banks.
When the Fed buys private sector assets from investors, it not only creates new deposits, it creates new reserves. This is because a new deposit (liability) in a bank must be balanced by an equivalent asset. When banks create deposits by lending, the equivalent asset is a loan. When the Fed creates deposits by buying assets, the equivalent asset is an increase in reserves, also newly created. So it does not matter how much lending banks do, if the Fed is creating new deposit/reserve pairs by buying assets from private sector investors then deposits will ALWAYS exceed loans by the amount of those new reserves.
Of course, banks do make a few pennies in interest by paying less on deposits than they receive on reserves. So cutting interest rates on excess reserves might encourage some banks to lend more to the private sector in order to compensate for loss of earnings on the reserve/deposit spread. But they might choose to increase credit spreads instead. They could do this by cutting deposit rates, but they don't have much room to do this, since if deposit rates are much below zero people will hoard physical cash instead. So they might raise interest rates on loans instead – which is not exactly an encouragement to households and businesses to borrow. Or they might simply absorb the cost, squeezing their profits and limiting their ability to grow their capital base by retaining earnings. I thought we wanted them to increase their capital? Hitting their profits with negative interest rates on reserves certainly isn't going to help with this.
The volume of excess reserves in the system is what it is, and banks cannot reduce it by lending. They could reduce excess reserves by converting them to physical cash, but that would simply exchange one safe asset (reserves) for another (cash). It would make no difference whatsoever to their ability to lend. Only the Fed can reduce the amount of base money (cash + reserves) in circulation. While it continues to buy assets from private sector investors, excess reserves will continue to increase and the gap between loans and deposits will continue to widen.
Banks cannot and do not "lend out" reserves - or deposits, for that matter. And excess reserves cannot and do not "crowd out" lending. We are not “paying banks not to lend”. Positive interest on excess reserves exists because the banking system is forced to hold those reserves and pay the insurance fee for the associated deposits. It seems only reasonable that it should be paid to do so.
Monetary liquidity operations and fiscal policy interventions. Bill Mitchell. Aug 29, 2015.
Central bank operations aim to manage the liquidity in the banking system such that short-term interest rates match the official targets which define the current monetary policy stance.
So the central bank sets a particular interest rate as its policy position, believing that rate will condition all the borrowing rates in the economy and produce desirable influences on total spending (via the interest rate sensitive components of spending – investment and consumer durables).
The fact that spending may not be particularly sensitive to interest rates movements (and levels) is beside the point in the context of our discussion.
Commercial banks maintain accounts with the central bank which permit reserves to be managed and also the clearing system to operate smoothly.
If the demand for reserves is higher than the supply at any point in time, then there will be upward pressure in what we call the interbank market which is where banks shuffle reserve balances between themselves according to their own particular needs on any one day.
The opposite pressure will occur if there are excess reserves (supply exceeds demand).
Banks need reserves to ensure all the transactions drawn against them will be honoured within the payments or clearing system. If they are caught short on a particular day then they seek the funds from other banks (who might have more reserves than they need) or, ultimately, from the central bank.
Banks have an incentive to hold minimal reserves because they usually earn low rates of return, which could include a zero return.
The central bank has to ensure that there is no excess demand or supply in this ‘cash’ market, which is what liquidity management is all about. By ensuring that all demands for reserves by the banks are met, the central bank can eliminate pressures on short-term interest rates and thus sustain its policy position – as represented by the current short-term interest rate.
In managing liquidity, the central bank may:
(a) conduct so-called open market operations which means they will buy from the banks to add reserves (when there is excess demand) or sell government bonds to the banks to drain reserves (when there is a shortage of reserves) to ensure there is no reserve imbalance in the cash market.
(b) buy certain financial assets at discounted rates from commercial banks in exchange for reserves (a ‘reserve drain’).
(c) impose penal lending rates (‘discount’ rates) on banks who require urgent funds (a ‘reserve add’).
In practice, most of the liquidity management is achieved through (a).
That being said, central bank operations function to offset operating factors in the system by altering the composition of reserves, cash, and securities, and do not alter net financial assets of the non-government sectors.
It is crucial to understand the last point about the effects of these monetary or liquidity operations on the net wealth of the non-government sector.
In addition to setting a lending rate (discount rate), the central bank also sets a support rate which is paid on commercial bank reserves held by the central bank.
Prior to the GFC, many countries set the rate at zero (the US and Japan, for example), while other nations, such as Australia and Canada gave some return on surplus reserve accounts which was below the policy target rate.
The support rate becomes the interest-rate floor for the economy.
The short-run or operational target interest rate, which represents the current monetary policy stance, is set by the central bank between the discount and support rate. This effectively creates a corridor or a spread within which the short-term interest rates can fluctuate with liquidity variability.
It is this spread that the central bank manages in its daily operations.
At the end of each day commercial banks have to appraise the status of their reserve accounts. In most nations, commercial banks by law have to maintain positive reserve balances at the central bank, accumulated over some specified period.
Those that are in deficit can borrow the required funds from the central bank at the discount rate. Alternatively banks with excess reserves are faced with earning the support rate which is below the current market rate of interest on overnight funds if they do nothing.
Clearly it is profitable for banks with excess funds to lend to banks with deficits at market rates. Competition between banks with excess reserves for custom puts downward pressure on the short-term interest rate (overnight funds rate) and depending on the state of overall liquidity may drive the interbank rate down below the operational target interest rate.
When the system is in surplus overall this competition would drive the rate down to the support rate.
The demand for short-term funds in the money market is a negative function of the interbank interest rate since at a higher rate less banks are willing to borrow some of their expected shortages from other banks, compared to risk that at the end of the day they will have to borrow money from the central bank to cover any mistaken expectations of their reserve position.
The main instrument of this liquidity management is through open market operations, that is, buying and selling government debt.
When the competitive pressures in the overnight funds market drives the interbank rate below the desired target rate, the central bank drains liquidity by selling government debt. This open market intervention therefore will result in a higher value for the overnight rate.
Importantly, we characterise the debt sales by the central bank as a monetary policy operation designed to provide interest-rate maintenance. This is in stark contrast to orthodox theory which asserts that debt-issuance is an aspect of fiscal policy and is required to finance deficit spending.
It is also important to understand the impact that fiscal deficit spending (government spending in excess of taxation receipts) has on the ‘cash’ position of the economy each day. The obverse impacts occur for surpluses.
Government spending (G) adds to bank reserves and taxation (T) drains them. So on any particular day, if G > T (a fiscal deficit) then the level of bank reserves are rising overall.
Any particular bank might be short of reserves but overall the sum of the bank reserves are in excess. It is in the commercial banks interests to try to eliminate any unneeded reserves each day. Surplus banks will try to loan their excess reserves on the Interbank market. Some deficit banks will clearly be interested in these loans to shore up their position and avoid going to the central bank’s discount window which usually will be a more expensive option.
The upshot, however, is that the competition between the surplus banks to shed their excess reserves puts downward pressure on short-term interest rates.
But the non-government banking system cannot by itself eliminate a system-wide excess of reserves that the fiscal deficit created. A loan by one bank to another doesn’t alter the reserve position overall.
But the central bank can obviously alter the overall reserve position – in this case it would sell bonds to the banks to drain reserves. The bonds are attractive to the banks because they are risk-free and bear interest.
finally, just as a bonus:
An Operational Perspective on QE in Canada. Brian Chang. Sept. 9, 2019.
Canadian market-watchers generally consider Quantitative Easing (QE) as the bazooka that was never fired by the Bank of Canada (BoC) during the financial crisis of 2008. In contrast with many other countries such as the US, Japan, and the EU, Canada was never forced to engage in unconventional monetary policies such as QE, as stresses in the Canadian financial system were ultimately resolved with conventional monetary policy measures and other short-term emergency liquidity injections which were eventually withdrawn by 2010. Many people have therefore come to believe that QE constitutes the biggest monetary policy hammer in the Bank of Canada’s toolkit should a large-scale financial crisis once again threaten the stability of the Canadian financial system.
In brief, Quantitative Easing refers to the process by which a country’s central bank creates reserves in the banking system and transfers these reserves to the banks in exchange for assets such as government bonds. One of the purported benefits of QE is that it serves to increase very liquid reserve balances in the banking system and in doing so entices banks to increase lending to the private sector and take on longer-term less-liquid assets (ie. make loans). The point of this article is not to debate the merits of QE or question its efficacy in reaching its stated goals, but to understand from a practical perspective the implications of implementing QE in Canada specifically.
In practice, the implementation of QE in Canada would require a significant operational change to the way monetary policy is conducted by the BoC, as dramatically increasing reserves in the Canadian banking system is not possible without significant changes to the BoC’s operational framework, currently implementing what is referred to as a “corridor system”. Presently, when the BoC sets the headline interest rate at its regular meetings, what it is really doing is setting the target for the “Overnight Rate”, which is the midpoint between something called the “Deposit Rate” and the “Bank Rate”. The Deposit Rate is simply the interest rate that the BoC pays banks for reserve balances which they hold at the BoC, and the Bank Rate is the interest rate that banks must pay to borrow reserves from the BoC. The Overnight Rate simply reflects the interest rate that banks pay to borrow reserves from one another.
Because banks can always earn the Deposit Rate by keeping reserves at the BoC, they have no incentive to lend reserves to other banks at a lower rate; and because banks can always borrow reserves from the BoC at the Bank Rate, they have no incentive to borrow reserves from other banks at a higher rate. Under this structure, banks with excess reserve balances will always try to lend reserves to banks at a higher rate than the Deposit Rate, and banks with a deficit position will always try to borrow reserves from other banks at a lower rate than the Bank Rate. Thus, the Deposit Rate forms the lower bound of the corridor, and the Bank Rate constitutes the upper bound. Banks lend reserves to one another somewhere within this corridor, with the Overnight Rate usually landing somewhere close to the mid-point of this range.
When the Overnight Rate deviates from the mid-point target within the corridor system, the BoC intervenes by adding or removing reserves balances in order for the Overnight rate to hit its target. When the BoC adds reserves to the banking system, it increases the supply of reserves which necessarily lowers its price (the overnight interest rate). Similarly, when reserves are removed from the banking system by the BoC, this reduces the supply of bank reserves and therefore increases its price (again, the overnight interest rate). It should be obvious from the above description that a large-scale increase in the supply of reserve balances (the very definition of QE) will serve to dramatically reduce the price of reserves, causing the Overnight Rate to crash below the BoC’s target. QE will effectively render the current corridor system ineffective at dictating monetary policy in Canada, forcing the BoC to abandon its current monetary policy framework if it wishes to engage in QE while at the same time having control over its trend-setting interest rate.
Ultimately, the implementation of QE in Canada will have the effect of forcing the Overnight Rate to the bottom of the corridor, meaning the Deposit Rate effectively becomes the Overnight Rate. Thus, for the BoC to set monetary policy while at the same time conducting QE, they will be throwing away their corridor system in exchange for a “floor” system. This is a system very much like the post-2008 system adopted by the United States in which the interest rate that central banks pay on excess reserves effectively becomes the de facto Overnight Rate. Under a floor system, the BoC sets the target policy rate by simply setting the Deposit Rate to equal the target rate, a process entirely independent of the amount of reserves in the system.
Because the interest paid on reserves by the BoC to commercial banks reduces income returned to the Government of Canada (since the BoC returns profits to the treasury), one can reasonably predict that a massive increase in reserves due to QE will likely open up renewed accusations of taxpayers providing a “subsidy” to private banks. But is this really accurate? After all, the commercial banks previously had higher-yielding government bonds, but due to QE, they now have a lower-yielding bank reserves instead which in aggregate reduces bank income. Is this really helpful to the banks?
Furthermore, interest that the Government of Canada was previously paying to the commercial banks is now being paid to the BoC as a result of QE, but these interest payments are simply remitted back to the treasury as BoC profits, which is actually a net benefit for the taxpayer. The implications to the taxpayer therefore seems surprisingly neutral, or at least not as bad as they might seem at first glance. The government basically gets an interest-free loan, but gets penalized via reduced profits from the BoC due to it now having to pay the Deposit Rate on a huge quantity of reserves. From a fiscal point of view, QE seems like a relative non-event
