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QE2 Is Equivalent to Issuing Treasury Bills

Randall Wray shows that quantitative easing will be ineffective except to the degree it can induce a shift in private portfolio preferences. He uses a recent post by hedge fund manager Warren Mosler to demonstrate that QE is the equivalent of issuing Treasury bills instead of bonds. Earlier posts making similar arguments are On Liquidity Traps and Quantitative Easing and Amateur Hour at the Federal Reserve.

Ultimately, one can influence the price or the quantity of something, but not both. And the Fed has decided to influence quantity when its stated aim is to influence price. Also see MMT: Market discipline for fiscal imprudence and the term structure of interest rates for a longer discussion of the expectations theory of interest rates that Professor Wray mentions below.

The confusion about QE2 has continued apace. I have previously written two longish pieces exposing QE2 as little more than a slogan, a policy that is not going to have any significant impact on US economic growth. (See here and here)

It is not likely to stimulate domestic spending, and if it is designed to crash the dollar in a last-ditch effort to turn America into a modern mercantilist nation, it will fail. Still, QE2 grabs the headlines, with the consensus worrying that it will (eventually) spark inflation. Me thinks not.

However, I have just seen an excellent post by Warren Mosler that is the clearest statement I have seen on the topic. (Go to his website here)  I usually hate and avoid long quotes in a column, yet Warren’s arguments simply cannot be improved upon. For those of you who do not know, Warren is a hedge fund manager who specializes in sovereign debt. He knows his topic. I have known him for almost two decades and he has never failed to educate me on the intricacies of government bonds. Hence, I am going to quote liberally from his analysis (with his permission) while adding a bit of commentary. Everything in italics is in his own words.

Here is the main conclusion, stated as succinctly as possible by Warren:

QE is the Fed buying longer term treasury securities and is functionally identical for the economy to the Treasury having issued 3 month T bills instead of those longer term securities the Fed bought. 

Got it? We could have saved a lot of unnecessary handwringing if the Treasury had just issued short-term debt in the first place. He goes on:

Now the more tricky part.

The yields on the approximately $13 trillion of various Treasury securities and reserve balances continuously gravitate towards what are called indifference levels. That means that for any given composition of reserve balances at the Fed and Treasury securities, there is a term structure of interest rates that adjusts to investor preferences at any given time. So, for example, with government providing investors with the combination of $2 trillion in reserves and $11 trillion in various Treasury securities, the yield curve will reflect investor preferences given the current circumstances. 

What Warren means is that it is about price, not quantity. All the assets will find a “home” to satisfy preferences, as prices (yields) adjust. What about expectations of Fed policy? Yes that affects rates as follows:

That means if investors expect Fed rate hikes, the front end of the curve would steepen accordingly.  And if instead they expect 0 rates for a considerable period of time, the curve would flatten for the first few years to reflect that.     

Simple? Yes, as plain as the nose on your face. It is just the expectations theory of interest rates. Let us move on to Bernanke’s “QE”: the purchase of more securities in an attempt to stimulate the economy.

If the Fed then buys another $1 trillion of securities, reserves go to $3 trillion and there are $10 trillion longer term Treasury securities outstanding. And to actually purchase those reserves, the Fed would have to drive the term structure of rates to levels where investors voluntarily are indifferent with that mix of offerings, given all the other current conditions. 

The Fed doesn’t force anyone to sell anything. It just offers to buy at prices (interest rates) that adjust to where people want to sell at those prices.

The Fed operates on price: to get markets to give up $1 trillion of securities it will need to offer prices to make them indifferent to what they are holding.

So even if the Fed owned a total of $10 trillion of securities, and there were only $3 trillion left outstanding for investors, if investors believed the Fed was going to hike rates by 3%, for example, the term structure of rates on Treasury securities would reflect that.

What I’m trying to say is that QE does not mean rates will actually go down.  The yield curve is still a function of investor expectations.So once we add in expectations, the Fed is playing a game that it cannot necessarily control.

QE2 might not drive long term rates down. For those who remember their Keynes, there is something called the square root rule: the lower the long rates go the harder it is to drive them lower due to fears of capital losses. We are almost certainly at that point already. Warren goes on to explain technical issues:

But the yield curve is also a function of ‘technicals.’  This means the quantity of 30 year securities offered for sale, for example, can alter the yield of that sector more than it alters the yields of the other sectors. This is because, in general, there tends to be fewer ‘natural’ buyers of 30 year securities than 3 month bills. For most of us, we are a lot more cautious about investing for 30 years at a fixed rate than for 3 months at a fixed rate. 

That is related to the “habitat” theory: we have preferred maturities that we like to hold. Again, a well-established position that is not controversial.

And it takes relatively large moves in 30 year rates to cause those investors to shift our preferences to either buy them if govt. wants to issue more, or sell them if the Fed wants to buy them back. On the other hand, there are pension funds who ‘automatically’ buy 30 year securities regardless of yield because they are matching the purchases to 30 year liabilities. 

So altogether, the yield curve is function of both investor expectations for interest rates and the ‘technicals’ of supply and demand (desires by issuers and investors).

Yes, so it is all “so complicated”—like Shrek’s onion once we peel back those layers. Impacts will be uncertain—it will depend on preferences and expectations.

And while there might be no amount of 3 month bills the Treasury could issue that would materially drive up 3 month T bill rates, relatively small amounts of 30 year bonds do alter the yields of 30 year securities.   Insiders would say the 30 year market is a lot ‘thinner’ than the 3 month market.

So what is QE? Let us try to get to the bottom of it. As Warren explains:

QE is nothing more than the government altering the mix of investments offered to investors. The Fed’s buying of longer term securities reduces the amount of longer term securities and increases the amount of reserves (effectively these are like one day securities). Interest rates, as always, continuously gravitate to reflect current investor expectations of future Fed rate changes and current ‘technicals’ of supply and demand. QE changes the technicals, and possibly expectations, and results in a yield curve that reflects those current conditions.

So all QE does is to potentially alter the term structure rates, as investors express preferences, given the securities of the varying maturities and reserves offered by the Fed and Treasury and all the current conditions.

Got it? It used to be called “operation twist”: the attempt to change long term rates relative to short term rates. Do you see why I call it a slogan? So what impact does QE2 have on the economy?

That brings us back to the question of what QE means for the economy, inflation, value of the currency, etc.  Which comes down to the question of what the term structure of rates means for the economy, inflation, the value of the currency, etc.

QE is nothing more than a tool for changing interest rates by adjusting the available supply of securities of various maturities.  And it’s not a particularly strong tool at that.  It’s the resulting interest rates that may or may not alter the economy, inflation, and the value of the dollar, etc. and not the quantities of reserves and Treasury securities per se.

All of those who are focusing on quantities, such as the $2 trillion of excess reserves the Fed created plus the additional $600 billion of excess reserves the Fed plans to create just do not get it. It is about price (rates) not quantity. There is no danger of running off into Zimbabwe land just because the Fed might be able to lower long rates. Does the Fed understand what it is doing, or is it “clueless in Seattle” as many claim? Warren’s conclusion:

It is clear to me that the FOMC does not fully understand this. If they did, they’d be in discussion with the Treasury about cutting issuance of bonds in the first place. And, additionally, If they wanted the term structure of interest rates to be lower, they would simply target their desired term structure of rates by offering to buy unlimited amounts of Treasury securities at their desired rate targets, and not worry about the mix between reserves and Treasury securities that resulted. 

Which is what they did in the WWII era.  And how they target the Fed Funds rate. With today’s central banking and monetary policy with its own currency, it’s always about price (interest rates) and not quantities.

Indeed! The easiest way to eliminate all the worries about government debt, and the debt burden, and the sustainability of the debt, and the burden on our grand kids is to simply stop issuing the debt. Our sovereign government does not borrow. It spends through “keystrokes” (as Bernanke has testified). Bond sales simply offer an interest-earning alternative to reserves. We now pay interest on reserves. QE2 is trying to drive bond yields down to the rate paid on reserves. By buying the bonds issued to drain reserves, to offer a higher interest rate than reserves pay.

Can anyone say “stop the nonsense”? Don’t sell the bonds. Then we don’t need the pinnacle of all stupidity: an alphabet soup of Congressional deficit commissions all worried about the sustainability of issuing more government debt. As Nancy said: “just say no”—to bond issues. Then we don’t need no more QE2.

L. Randall Wray is a Professor of Economics at the University of Missouri-Kansas City and Research Director with the Center for Full Employment and Price Stability as well as a Senior Research Scholar at The Levy Economics Institute and author of Understanding Modern Money.

Professor Wray also blogs at New Economic Perspectives, and at New Deal 2.0.

A version of this article first appeared on Benzinga

Randall Wray

About 

L. Randall Wray is a professor of economics and research director of the Center for Full Employment and Price Stability at the University of Missouri–Kansas City. His current research focuses on providing a critique of orthodox monetary policy, and the development of an alternative approach. He also publishes extensively in the areas of full employment policy and the monetary theory of production. Wray received a B.A. from the University of the Pacific and an M.A. and a Ph.D. from Washington University, where he was a student of Hyman Minsky.

61 Comments

  1. rn says:

    While Mosler’s article is extremely illuminating and accurate, I believe some of statements by Randall Wray are inaccurate. For example, “the Fed has decided to influence quantity when its stated aim is to influence price” is not correct. Fed is not trying to influence quantity.

    Does this help ? the answer is Yes – to some extent. It reduces the interest burden of the govt, thereby giving more leeway in balancing the budget.

    Can it backfire? possibly.
    Does the fed know ? The answer is yes.
    Do they have a choice ? No. In the absence of any fiscal policy, this is the only game in the town.

    • Wray did not make that statement. It was a CW editorial lead-in and it is accurate. For example, Moseler says “It is clear to me that the FOMC does not fully understand this. If they did, they’d be in discussion with the Treasury about cutting issuance of bonds in the first place. And, additionally, If they wanted the term structure of interest rates to be lower, they would simply target their desired term structure of rates by offering to buy unlimited amounts of Treasury securities at their desired rate targets, and not worry about the mix between reserves and Treasury securities that resulted.”

      What he means by that is you can’t target the quantity of QE and expect to control the price (rate of interest) of Treasuries. You must be poised to defend a price (rate) with unlimited quantity because one cannot control both price and quantity. That’s why Krugman was talking about $8-10 trillion of QE.

      And while the interest burden of government is reduced, so too is the interest income of households and businesses. If this is the only game in town, it’s not a very good one.

      • rn says:

        Quantum of bond issuance is primarily an outcome of congressional decisions ( budget, deficit and debt limits). Treasury has very little control over the quantity. All treasury can do is to do is to decide the term structure in terms of 30 yr/10 yr etc. I am not convinced that FOMC is targetting quantity, unless you mean that quantity represents MZM or something similar to that.

        I agree with you “it is not a good one”

        • When I say targeting quantity I mean specifying a specific quantity it wishes to buy instead of a price(rate). By saying it will do 600billion in QE the fed is ‘targeting quantity ‘ instead of saying it will buy however much 5 year paper it must to get a specified rate of interest.

  2. rn says:

    Thanks for the clarification. While I do not respect for Greenspan’s decisions, I think Ben’s hands are tied and he does not deserve the criticisms. I believe most, if not all, of the blame for the post-Lehman problems are with Congress for economic illiteracy , incompetence or political intransigency.

  3. Sobers says:

    My head hurts. I’m just a simple man, but this makes no sense at all. How exactly is the Fed magicking $600bn out of thin air and buying long term bonds the same as the Treasury issuing 3 month bills? Does anyone print money when the Treasury issues 3 month bills? Not as far as I know. All I can see is that there is $600bn of extra money floating around after QE2 than before, which given the same amount of stuff in the economy, equals inflation at some point, unless the Fed sells those very same long term Treasuries back into the private sector at some point and destroys the money it gets for them. Which I very much doubt it will ever do.

    QE is just a snazzy way of saying ‘We’re printing money’ and no amount of high flown theorising will change that basic fact. Otherwise why doesn’t every Central Bank do QE all the time? A lot easier than having to sell your State debt to real people. Just get the Central Bank to buy it with funny money, and spend it in the economy. What could possibly go wrong? Its never gone wrong before has it………………….????

    • gaius marius says:

      it’s only “printing money” to the extent that it’s also “unprinting treasury debt”.

      the fed is conducting an asset swap — the banks are gaining reserves, and losing some 3-5 year treasury debt. the reserves function very much like as 3-month t-bills (with the exception that they cannot be shifted off balance sheet to any non-bank). from the banks’ perspective — that is, from the perspective of the entire private sector — very little has changed.

      it is true that the fed expands its balance sheet, but i’m not sure what if any consequence that has for anyone or anything. there’s no more money in circulation than there was before the swap; the composition of the assets in the private sector has changed very slightly. the idea that anything has materially changed is a bit daft, imo, and more a reflection of (very) widespread popular misunderstanding of what’s happening than anything real. it isn’t inflationary as far as i can tell.

      the fed in general manages the fed funds rate by creating/destroying reserves in this fashion all the time. the reason the fed doesn’t run QE all the time is that they normally don’t want the fed funds rate at zero.

      • That’s right, this is an asset swap, nothing more. The Fed is getting bonds and the bank is getting what I am calling ‘money’. Where did the money come from? The Fed printed it out of thin air. But there are no new financial assets created. Again it’s a swap of money for bonds as the Fed does when targeting the Fed Funds rate.But the whole expansion of the balance sheet is troubling to me. Going from 800 billion to $3 trillion – that’s a step too far. And politically there will be consequences.

        • Why is it troubling you? Do you think that somehow it is “inflationary”?

          I think one can certainly criticise the Federal Reserve for its malign
          neglect of the housing bubble during the mid-2000s, but the only thing I find
          particularly troublesome here is the idea that a central bank, even if only
          through an “open mouth policy” appears to be encouraging speculation which
          will end badly. That’s very different, however, from the issue related to
          the expansion of the balance sheet, much of which in effect consisted of
          taking the “shadow banking” out of the shadows and simply placing it on the
          Fed’s balance sheet explicitly. I have less problem with that than the
          objectives or motives which are currently underlying the Fed’s inept policy.

          In a message dated 11/18/2010 3:10:29 P.M. Mountain Standard Time,
          writes:

          Edward Harrison wrote, in response to gaius marius:

          That’s right, this is an asset swap, nothing more. The Fed is getting
          bonds and the bank is getting what I am calling ‘money’. Where did the money
          come from? The Fed printed it out of thin air. But there are no new
          financial assets created. Again it’s a swap of money fro bonds as the Fed does when
          targeting the Fed Funds rate.

          But the whole expansion of the balance sheet is troubling to me. Going
          from 800 billion to $3 trillion – that’s a step too far. And politically
          there will be consequences.

          Link to comment: http://disq.us/sdhkh

          • My problem with the balance sheet expansion is what you would hear from anyone who has a visceral negative reaction to central planning: the expansion is the product of centralized planning. I can understand temporarily lending during a liquidity crisis at a penalty rate but what the Fed has done all along is wrong. It never lent against good assets at a penalty rate during the crisis, making it difficult to discern who was illiquid and insolvent. This enabled insolvent companies to masquerade as solvent while the economy went through terrible unemployment and recession. It transfered risk onto the taxpayer without any oversight because it refused all FOIA requests and now it is sat there with a balance sheet 4 times the size it was just two years ago.

            And they now want to do more. My point is that it makes no sense to anyone except those who are already predisposed to activist government.

          • My point on the balance sheet expansion is that it is in fact not really a balance sheet expansion, so much as taking a balance sheet “out of the shadows” and on to the Federal Reserve’s balance sheet.
            Banks with surplus funds lent them to the Fed by holding excess reserve balances, and banks that needed funds borrowed them from the Fed through the discount window. Foreign banks that needed dollar funding got it through their own central bank, which got it from the Fed through the liquidity swap facility. Banks that were short of collateral eligible for discount borrowed directly through the new commercial paper facility. Shadow banks that could not deposit in the Fed instead bought Treasury bills, and the Treasury deposited the proceeds at the Fed.

          • My point is that to the layman when you see the Fed’s balance sheet expanding, banks making lots of money, credit growth subdued, unemployment high, etc, etc the only conclusion they can draw is that the Fed is printing a bunch of money and handing it out to their cronies on Wall Street. That’s what people in America are thinking. Of course, there is some truth to this. So, at a minimum, politically, this is radioactive.

            But given the fact that it is weak tea as policy, why do it then? If jobs have gone missing, it’s up to the private sector and Congress to do something. In my view the Fed should have a very limited mandate. It has already shown how it creates bubbles and doesn’t pop them. And it is completely insulated from its decisions despite checks and balances.

          • I agree with your last point. I would just as soon keep rates at zero perpetually and use taxes to regulate demand. Then you’d pretty well put the Fed out of business. Of course, I realise this is about as likely as my beloved Maple Leafs hockey team winning the Stanley Cup!

            In a message dated 11/18/10 16:35:33 Mountain Standard Time, writes:
            Edward Harrison wrote, in response to Marshall Auerback:

            My point is that to the layman when you see the Fed’s balance sheet expanding, banks making lots of money, credit growth subdued, unemployment high, etc, etc the only conclusion they can draw is that the Fed is printing a bunch of money and handing it out to their cronies on Wall Street. That’s what people in America are thinking. Of course, there is some truth to this. So, at a minimum, politically, this is radioactive.

            But given the fact that it is weak tea as policy, why do it then? If jobs have gone missing, it’s up to the private sector and Congress to do something. In my view the Fed should have a very limited mandate. It has already shown how it creates bubbles and doesn’t pop them. And it is completely insulated from its decisions despite checks and balances.

            Link to comment: http://disq.us/sdric

          • gaius marius says:

            good points both — i’m particularly aghast at how wall street is pushing ZIRPed call money into equities and commodities, kicking off a “starvation bubble” in the third world — but i also think the papering-over of the big banks’ asset quality problem is about to be undone with the help of ZIRP anyway. income that was being bolstered by increases in debt is now being eaten away as income is leaked into deleveraging at the same time as interest income system-wide is being gradually rolled into non-existence.

            the fed thinks its faced with an asset-price problem (particularly in housing) and has attacked asset prices as best it can to minimize balance sheet damage.

            but in reality it’s already lost the balance sheet war and is now faced with a growing income disaster that a ZIRP designed to fight the last, lost war is directly aggravating.

          • I completely concur with all of the points you’ve made on this subject, Gaius Marius!

          • Marshall, we can dream. I dream of Semin and Ovechkin hoisting the cup. One day the choking will be over.

          • I like the Caps’ odds better than Toronto’s!

            In a message dated 11/18/10 18:01:25 Mountain Standard Time, writes:
            Edward Harrison wrote, in response to Marshall Auerback:

            Marshall, we can dream. I dream of Semin and Ovechkin hoisting the cup. One day the choking will be over.

            Link to comment: http://disq.us/se0j9

  4. haris07 says:

    Jim, as I understand it, yes, someone does print money when the Treasury issues 3 month bills – the Fed. The Fed actually creates the money that is used to purchase the T bills. Note that money is being spent into existence by the Treasury, but the “cash” is being printed (electronically) by the Fed.

    While I understand the technical aspects and do agree that QE is just issuing 1 day T bills, I am still at odds with the idea that this doesn’t have any impact anywhere. Otherwise, as Jim above has asked, why not have every Central Bank just do QE’n’ all the time there is slack in the economy and get all this done and over with. Any time there is a recession, just QE it away. If it takes $8 trillion (and because of slack in labor and capital, there acmn’t be inflation), do it.

    I still see a couple of problems (and I am sure there are more):
    1. You are creating cash but not any “value”. Inefficient channels prevent it from going to the public (because there is no demand) and instead excess reserves are being speculated upon to drive up assets in a bubble. Creating cash without adding “value” (or it being used to add “value”) to the society will result in inflation.
    2. Channeling the cash efficiently is not practically possible (this is sort of a corollary to 1 above). End result is overvalued assets and bubbles.
    3. While technically QE just retires longer term Treasuries with newly minted cash and therefore doesn’t actually change govt liabilities, my question is doesn’t the newly minted cash retire old Treasuries which were issued to finance productive assets (yes, I know Treasuries don’t actually “finance” anything and yes I also know that the recent issu of Treasuries could have been deployed for similarly futile unproductive asset bubbles, but take this argue long back enough and you will get the idea), then again you are creating $ without it being deployed towards productive assets. Similar point as # 1 above. Where is the “value creation”?
    3. What about carry trade effects, excess reserves lead to $ flooding into emg mkts and commodities creating inflation there in turn causing price rises here as well (at least in certain commodities)?

    The single biggest issue I have with all this is still the same one that I have had since a year or so ago – if it is so simple, what is preventing it from happening? Why not print $5 trillion and avoid this whole damn recession? And the next step to this, if you can indeed solve the problems this way, what prevents citizens from not working, continue speculating and being bailed out by central bank printing every time there is a bubble i.e. why should I actually produce or do any work? I know that the central bank can just print and solve any temporary recession, so I just sit and speculate. I might lose temporarily while asset prices fall or crash, but secure in my knowledge that the central bank will just print, I have no reason to work. This then leads to sloth and eventual decay of the citizenry – doesn’t it?

    What am I missing?

  5. Mondo says:

    Warren Mosler’s post is very illuminating – but is the assessment still true if and when the Fed goes beyond buying various forms of US government debt, i.e. if and when they start buying other domestic securities ? At that point I would say the money-printing game starts, correct ?

    • I would call any QE ‘money printing.’ But no money gets into circulation if there is no credit transmission mechanism. I know the MMT folks see it this way. The key is that the Fed is conducting fiscal policy. For example, if the Fed bought foreclosed houses instead of treasuries or bought municipal bonds, you clearly have fiscal policy and not monetary policy. QE as now proposed is quasi-fiscal and beyond the Fed’s mandate.

    • gaius marius says:

      if they, for example, swap out MBS a par for reserves, then yes it can make a difference to the credit profile of the private sector. reserves have no risk of loss, require no loss reserve, cannot be frozen out of repo markets. still net financial assets in the private sector are not created, but the risk profile of the banks would have changed materially.

      @PragCapitalist has noted that QE2 might be a lead-in to exactly that kind of asset purchasing in the event of further housing market deterioration, fwiw.

      • Actually,I’m the one who broached the MBS topic first. See here:http://www.creditwritedowns.com/2010/10/blanchflower-the-fed-should-buying-munis-and-monetize-state-debt.htmlMy conclusion – other than the fact that its fiscal policy and shouldn’t happen is that the Fed is politically constrained. It won’t happen in my view – UNTIL things get much, much worse. But, I would concede that if you are going to print money, you might as well do it in a way that actually relieves the debt stress which normal QE does not.

        • gaius marius says:

          LOL i might have known, ed — ahead of the curve as usual!

          i tend to think you’re right, too, on the political consequences. the fed runs a powerful political fiefdom for the banks and cannot be eager to go to the treasury, hand in hand, to ask to be recapitalized by the treasury. particularly with ron paul setting the agenda in the house committee. democracy is again about to become the technical impediment it was always designed to be.

  6. I tried to get Marshall on here to do an in-depth explanation but I’ll have to step in with a quicker hit here. My suggestion is to read the posts linked at the top and they may help put all of this in perspective.

    My bottom line is this: QE only increases reserves, it does not directly influence credit. And to the degree it influences interest rate, it does so by either changing private portfolio preferences (risk-on trades, longer duration) or by jamming it on and offering virtually unlimited liquidity at a specific point on the curve. That’s what the 8-10 trillion is about. This is weak tea and it has the Fed doing fiscal policy. It’s ineffective and politically radioactive to boot. I say leave it alone.

    • Okay, here’s my attempt at a more in-depth conversation, but I would also
      urge any of you who really want to understand this to read Randy Wray’s
      excellent explanation here:
      _http://www.newdeal20.org/2010/10/18/qe2-wont-save-our-sinking-ship-23653/_
      (http://www.newdeal20.org/2010/10/18/qe2-wont-save-our-sinking-ship-23653/)

      And here:
      _http://www.newdeal20.org/2010/11/11/just-what-is-bernanke-up-to-26615/_
      (http://www.newdeal20.org/2010/11/11/just-what-is-bernanke-up-to-26615/)

      To repeat, QE doesn’t “create” any new net financial assets. As Randy Wray
      says, it’s a slogan, not a policy. It simply constitutes a balance sheet
      swap from Treasuries to reserves. The Fed buys treasuries from the banks and
      swaps the proceeds into reserves. The banks don’t lend out the reserves.
      So, that’s the first thing you need to know — reserve accounts are not
      made up of money held in reserve in case a loan goes bad, they are money held
      at the Federal Reserve for payment settlement. The reserves of money held
      in case loans go bad are capital. Reserves are held as assets at the bank
      and liabilities at the Fed. Capital is held as an equity liability at the
      bank, and does not exist at the Fed at all.

      Misunderstanding what reserves and capital are and how they are accounted
      for is a fundamental error in macroeconomics. It also explains why banks
      aren’t making loans, nor is there any inflation, even though reserve accounts
      are so swollen. Reserves are for payment settlement, not loan enablement,
      so excess reserves have no impact on anything (except letting banks really
      really settle payments).

      The reserves are there for SETTLEMENT PURPOSES or interbank lending.
      That’s it.

      In fact, reserves, functionally, are nothing more than 1 day t bills.

      And, for all practical purposes, the difference between issuing 1 day t
      bills and 3 month t bills is inconsequential.

      So since currently the shortest thing the Treasury issues are 3 mo bills,
      I can say that:

      QE- the Fed buying longer term treasury securities- is functionally
      identical for the economy to the Treasury having issued 3 month t bills instead
      of those longer term securities the Fed bought.

      Now the more tricky part.

      The yields on the approx. $13 trillion of various Treasury securities and
      reserve balances continuously gravitate towards what are called indifference
      levels.

      That means that for any given composition of reserve balances at the Fed
      and Treasury securities (also Fed accounts), there is a term structure of
      interest rates that adjusts to investor preferences at any given time.

      So, for example, with govt. providing investors with the combination of $2
      trillion in reserves and $11 trillion in various Treasury securities, the
      yield curve will reflect investor preferences given the current
      circumstances.

      That means if investors expect Fed rate hikes, the front end of the curve
      would steepen accordingly. And if instead they expect 0 rates for a
      considerable period of time, the curve would flatten for the first few years to
      reflect that.

      If the Fed then buys another $1 trillion of securities, reserves go to $3
      trillion and there are $10 trillion longer term Treasury securities
      outstanding.

      And to actually purchase those reserves, the Fed would have to drive the
      term structure of rates to levels where investors voluntarily are indifferent
      with that mix of offerings, given all the other current conditions.
      The Fed doesn’t force anyone to sell anything.
      It just offers to buy at prices (interest rates) that adjust to where
      people want to sell at those prices.

      So even if the Fed owned a total of $10 trillion of securities, and there
      were only $3 trillion left outstanding for investors, if investors believed
      the Fed was going to hike rates by 3%, for example, the term structure of
      rates on Treasury securities would reflect that.

      What I’m trying to say is that QE does not mean rates will actually go
      down. The yield curve is still a function of investor expectations.

      But the yield curve is also a function of ‘technicals.’
      This means the quantity of 30 year securities offered for sale, for
      example, can alter the yield of that sector more than it alters the yields of the
      other sectors.

      This is because, in general, there tends to be fewer ‘natural’ buyers of 30
      year securities than 3 month bills.
      For most of us, we are a lot more cautious about investing for 30 years at
      a fixed rate than for 3 months at a fixed rate.
      And it takes relative large moves in 30 year rates to cause those investors
      to shift our preferences to either buy them if govt. wants to issue more,
      or sell them if the Fed wants to buy them back.

      On the other hand, there are pension funds who ‘automatically’ buy 30 year
      securities regardless of yield because they are matching the purchases to
      30 year liabilities.

      So altogether, the yield curve is function of both investor expectations
      for interest rates and the ‘technicals’ of supply and demand (desires by
      issuers and investors).

      And while there might be no amount of 3 month bills the Treasury could
      issue that would materially drive up 3 month t bill rates, relatively small
      amounts of 30 year bonds do alter the yields of 30 year securities.
      Insiders would say the 30 year market is a lot ‘thinner’ than the 3 month market.

      So what is QE?

      QE is nothing more than the govt. altering the mix of investments offered
      to investors.

      The Fed buying longer term securities reduces the amount of longer term
      securities and increases the amount of reserves (one day securities)

      Interest rates, as always, continuously gravitate to reflect current
      investor expectations of future Fed rate changes and current ‘technicals’ of
      supply and demand.

      QE changes the technicals, and possibly expectations, and results in a
      yield curve that reflects those current conditions.

      So all QE does is alter the term structure rates, as investors express
      preferences for the term structure of interest rates, given the securities and
      reserves of the varying maturities offered by the Fed and Treasury and all
      the current conditions.

      That brings us back to the question of what QE means for the economy,
      inflation, value of the currency, etc.

      Which comes down to the question of what the term structure of rates means
      for the economy, inflation, the value of the currency, etc.

      QE is nothing more than a tool for changing interest rates by adjusting the
      available supply of securities of various maturities (technicals). And
      it’s not a particularly strong tool at that.

      It’s the resulting interest rates that may or may not alter the economy,
      inflation, and the value of the dollar, etc. and not the quantities of
      reserves and Treasury securities per se.

      And it is clear to me that the FOMC does not fully understand this.

      If they did, they’d be in discussion with the Treasury about cutting
      issuance.

      And, additionally, If they wanted the term structure of interest rates to
      be lower, they would simply target their desired term structure of rates by
      offering to buy unlimited amounts of Treasury securities at their desired
      rate targets, and not worry about the mix between reserves and Treasury
      securities that resulted. Which is what they did in the WWII era. And how
      they target the fed funds rate.

      In a message dated 11/18/2010 2:46:04 P.M. Mountain Standard Time,
      writes:

  7. P.R. Tcherneva says:

    As I discussed in my paper, which Ed referenced earlier (thanks!) the fiscal components of monetary policy occur only when the Fed finances the Treasury’s purchases of real goods and services, privately issued liabilities, or foreign currencies. Buying treasuries does not have a fiscal component (it’s swapping one govt liability for the other and net financial assets do not change, except maybe for the lost interest income).

    • As usual, Professor Tcherneva is correct. And her paper is truly a scholarly masterpiece on the subject. As I said, to the extent that QE affects the fiscal channel (in a highly limited way), it is negative.

      In a message dated 11/18/10 15:27:32 Mountain Standard Time, writes:

  8. Thank you Pavlina and Marshall for getting into this. As you can tell I DO think of traditional QE as quasi-fiscal. And its significant politically to understand it that way. We can explain until the cows come home that there are no net financial assets being created but when people see the expansion of the Fed’s balance sheet combined with the still high un- and underemployment, they go ballistic.

    It’s the Fed equivalent of Obama’s half-hearted fiscal stimulus. If you are going to do something non-traditional, it had better work. Better to fail conventionally than unconventionally is hard-wired into human interactions. When Steve Waldman talks about the ‘morality’ of economics, that’s what he means:
    http://www.interfluidity.com/v2/983.html

    I know Marshall has made this point but some are unconvinced. But ultimately the way you talk about these things is significant.

    • I don’t even view it as quasi-fiscal. To the extent that QE is “fiscal”, it acts in a negative way as it deprives savers of interest income and therefore diminishes the impact of the “fiscal channel”. It’s just stupid policy; nothing but smoke and mirrors. All sound and fury, signifying nothing, as the great Bard once wrote.

      In a message dated 11/18/10 15:37:44 Mountain Standard Time, writes:

  9. rn says:

    It is very simple, folks.

    Congress passes the budget with deficit and sets the debt limit. Today it is 13 T. Treasury has already issued combinations of 30 year/ 10 year / 5 year / 3 months treasury bonds/notes / bills etc upto 13T. This 13T is sitting in the accounts of your mutual funds and also with China / Japan and also with Federal reserve.
    Foreigners ( China / Japan / OPEC ) have about 4T. Federal Reserve had about 1T before Lehman-crisis and has about 3T today. the remaining 6T are in your mutual funds as well as in the balance sheets of corporations.

    Federal Reserves is the authority for issuing the US dollar currency, which is actually a govt debt with zero interest rate. Before Lehman crisis, federal reserve had 1 T assets ( ie. treasury bonds/notes/bills) and has issued 1 T equivalent of US dollar currency to public.

    Before QE2, till last month, federal reserve bought 2 T worth of (toxic) assets from the banks and issued 2 T equivalent of US dollar currency to the banks.

    With QE2, Federal reserve has decided to buy an additional 600 Billion of treasury bonds/notes/bills from public at large, in exchange for 600 billion US dollar currency.

    Federal reserve is only the middleman here. It is the congress which decides how much debt to raise and how to spend it. Raising debt per se is not bad, as long as the money is used for “public investments” such as public infrastructure, research or education. In stead, if the congress decides to “spend” it on banks and other lobbies that is the real problem.

  10. My point holds, “what the Fed has done all along is wrong. It never lent against good assets at a penalty rate during the crisis, making it difficult to discern who was illiquid and insolvent. This enabled insolvent companies to masquerade as solvent while the economy went through terrible unemployment and recession.”As for fiscal policy at the Fed and QE, beyond the terminology, you Marshall, Pavlina and I probably agree on this, fiscal is better.

  11. rn says:

    I think we are broadly in agreement. But there are some subtle differences in our views.
    Fed reserve buying toxic assets from private organizations (banks), last year, is beyond their scope, roles and responsibilities. I would consider that to be even illegal.

    I do not think monetary policy is a substitute for fiscal policy. But Fed’s role in QE2 of 600 billion USD is part of their traditional role / normal day to day open market operations – except it is too big in size. Technically it is within their scope , if they choose to buy of all of the 13 T debt.

    Is it useful to indulge in such a big open market operations ? Under normal circumstance, my answer is No. But when the politicians are unwilling to increase the debt to invest in public infrastructure, expansionary monetary policy is the only game in town.

    Fed deserves criticism for their role in monetizing the toxic assets. But, criticizing Fed Reserve for QE2, is not appropriate. This criticism should be 100 % directed at the congress and not Fed reserve.

  12. Larry Lapham Jr. says:

    I am a layman with a simple question. If a bank is meeting its reserve requirements with amount X, and the fed offers to buy some assets (t- bills) at a “profit” to the bank (by increasing its reserves) by YY for a total reserve amount of XYY, Why doesn’t that bank “see” the surplus reserve (YY) as an opportunity to lend out that amount to VCs or other attractive opportunities?? As more banks compete for those opportunities with lower rates the Great American Ingenuity engine fires up and life is good again. What am I missing.

    • It’s demand for credit by credit worthy customers that is the issue. If
      credit worthy customers wanted to borrow the bank would supply them with the
      credit. Too many either don’t want the credit or aren’t good credit risks.

      ————–
      Edward Harrison
      http://twitter.com/edwardnh
      Sent from my mobile telephone

      • Larry Lapham Jr. says:

        Thanks for the answer I think. If I read you correctly the increase in reserves I describe (in addition to the 2 trillion you reference below) will do nothing to stimulate the economy because, in the banks’ opinion, America does not in fact have a Great Engine of Ingenuity, it does not even have credit worthy prospects for investment. As unbelievable as it sounds to me how can this be other than a death sentence for the US economy? Should I pull my 401K and buy gold?

  13. Sobers says:

    This how I see it (simplistic as it may be): ABC bank has $100m. It decides to invest this money in a bond issued by the State. It no longer has $100m, the State does, which it spends on whatever States waste (sorry spend) their money on. It does have a bit of paper saying it’ll get x% interest and its $100m back in (say) 10 years time. All fine so far. There was $100m in the economy before, and $100m after.

    Now the Central bank comes along and says ‘We’ll buy your bit of paper for $105m’. ABC bank think ‘Well its a nice little bit of profit, lets go for it.’ So they sell their bit of paper for $105m and give it to the Central Bank. BUT now there is $205m in the economy, as the bank have $105m, and the original $100m is still floating around, wherever the State spent it.

    You all say the extra cash is in ‘reserves’ only, and cannot be loaned out. Why? Are all State bonds that banks hold held as reserves that they can never spend, or loan out? Do they not own State bonds as pure investments as well? Which they may sell to the Central bank if offered a little profit? And then do the same thing all over again, as the State is issuing debt like a waterfall?

    How is QE NOT the monetisation of State Debt? Cos it REALLY REALLY looks like it to me!

    • What you just said makes no sense to me. Let me see if I can explain what’s happening:1. The Fed conjures up previously non-existent dollar credits and places it as a credit on its ledger.2. It uses these credits to purchase financial assets – in this case Treasury bonds.3. After the transaction, bank reserves have increased but net financial assets in the economy have not since the bonds are no longer in circulation but at the Fed4. Now the banks could lend against the money they have in reserve. However a. banks already have $2 trillion in excess reserves and b. don’t normally check reserves before loaning to a creditworthy customer.So the question everyone is debating is whether the new reserves now in the system and the lack of bonds alter interest rates or lending in any way. This has nothing to do with municipal bonds. If the Federal Reserve were buying municipal debt, it would.

      • Sobers says:

        How can net financial assets not have increased when you’ve just created some out of thin air? You’re ignoring the fact that a bank doesn’t just end up with a Treasury bond on its books by magic. The Treasury doesn’t give them away for free. They had to be purchased first, with cash. That cash was in the economy, in the bank, then it was passed to govt in return for the Bonds, then was returned to the real economy by the govt when it used it to buy something, or pay out as welfare etc. After QE the Bank has as much cash as it had to start with, the Fed has the Bond, AND the initial money the bond was bought with is out there in the economy too. What am I missing?

        • The initial transaction is the one you’re missing. The Fed puts cash into the economy and takes bonds out. It is a swap.

          • Sobers says:

            Right, I get that. The banks can’t lend out their reserves. But can they buy more Treasuries with them? Because if they can, is this not monetising the State debt? Its just a conveyor belt from the Fed (printed money) to the State (who spends the money in the real economy) with the banks being the middle man that allows the big wigs to claim they aren’t monetising the debt? The crucial point is – if there was no QE would there be enough buyers for Treasuries?

          • Again it has nothing to do with States. States are constrained by balanced budget amendments. Nothing the Fed does has any effect on the states’ ability to deficit spend.

          • Jim,

            It’s not “monetising” the debt. As long as the Fed has a mandate to
            maintain a target fed funds rate, the size of its purchases and sales of
            government debt are not discretionary. Once the Federal Reserve Board of
            Governors sets a fed funds rate, the Fed’s portfolio of government securities
            changes only because of the transactions that are required to support the funds
            rate. The Fed’s lack of control over the quantity of reserves underscores
            the impossibility of debt monetization. The Fed is unable to monetize the
            federal debt by purchasing government securities at will because to do so
            would cause the funds rate to fall to zero. If the Fed purchased securities
            directly from the Treasury and the Treasury then spent the money, it’s
            expenditures would be excess reserves in the banking system. The Fed would be
            forced to sell an equal amount of securities to support the fed funds target
            rate. The Fed would act only as an intermediary. The Fed would be buying
            securities from the Treasury and selling them to the public. No monetization
            would occur. To monetize means to convert to money. Gold used to be monetized
            when the government issued new gold certificates to purchase gold. In a
            broad sense, federal debt is money, and deficit spending is the process of
            monetizing whatever the government purchases. Monetizing does occur when the
            Fed buys foreign currency. Purchasing foreign currency converts, or
            monetizes, that currency to dollars. The Fed then offers U.S. Government
            securities for sale to offer the new dollars just added to the banking system a
            place to earn interest. This often misunderstood process is referred to as
            sterilization.

            When we talk about central banking operations being about “price not
            quantity” it simply means that the Fed

            can simply target their desired term structure of rates by offering to buy
            unlimited amounts of Treasury securities at their desired rate targets,
            and not worry about the mix between reserves and Treasury securities that
            resulted.

            In a message dated 11/20/2010 3:02:34 A.M. Mountain Standard Time,
            writes:

            Jim (unregistered) wrote, in response to Edward Harrison:

            Right, I get that. The banks can’t lend out their reserves. But can they
            buy more Treasuries with them? Because if they can, is this not monetising
            the State debt? Its just a conveyor belt from the Fed (printed money) to
            the State (who spends the money in the real economy) with the banks being the
            middle man that allows the big wigs to claim they aren’t monetising the
            debt? The crucial point is – if there was no QE would there be enough buyers
            for Treasuries?

            Link to comment: http://disq.us/siu3f

        • Jim,

          All central banks, whether they are engaging in “quantitative easing” or not. We can think of the supply of reserves as “horizontal”, that is, as an infinitely elastic supply at the target interest rate. The simplest way to operate such a system is to offer “overdraft” facilities at the central bank, lending on demand at the target rate (this is done in Canada). Knowing that they can obtain reserves any time they want, banks would never hold substantial excess reserves, since they could borrow them as needed.

          Here’s Randy Wray’s explanation: “The Fed has never explicitly operated this way, preferring to supply most reserves through its open market operations (purchasing treasuries) while imposing “frown” costs on banks that come to the discount window. Most of the time, this does not really matter. However, when the financial tsunami hit, the fed funds market froze up as banks refused to lend to one another, even on the basis of good collateral. There was a general run to liquidity, and no bank felt it could get enough reserves to see it through the crisis. The Fed played around with an alphabet soup of auction facilities rather than simply announcing that it would supply reserves on an unlimited basis to all comers. That cost the economy dearly by dragging out the liquidity crisis. Fortunately, the Fed finally stumbled upon the obvious: supplying reserves in sufficient quantity. The liquidity phase of the crisis passed, and the Fed got the short-term interest rates down to i
          ts near-zero target.
          So here is where Bernanke’s pet, quantitative easing, came in. Conventional wisdom is that the once the central bank takes the short-term rate to zero, it has shot its wad. Nayeth, sayeth Bernanke — the Fed can continue by flooding banks with excess reserves, which they do not want to hold. Some commentators have said that banks would eventually begin to lend out the excess reserves, seeking a higher interest rate than the Fed pays them. One hopes Bernanke never made that mistake — banks do not lend reserves (except to one another), since they exist only as entries on the Fed’s balance sheet. Only an institution with a “checking account” at the Fed can hold reserves, so there is no way a bank can lend these to households or firms (which do not have accounts at the Fed). So Bernanke presumably understood that if for some reason holding excess reserves caused banks to want to increase lending, this would simply shift the reserves around the banking system while leav
          ing the outstanding quantity unchanged. But that means that offering Canadian-like overdraft facilities, promising banks they can have reserves anytime they want them, would have had the same impact as quantitative easing. Rather than actually holding excess reserves, the banks would have been just as happy knowing that they were safely “locked up” at the Fed and available anytime they were needed. In other words, pumping about $1.5 trillion into the banks would be no different than telling them the Fed would supply any amount at any time.
          In sum, adding excess reserves to bank portfolios will not, by itself, do anything if the overnight interest rate has already been driven down to its near-zero target. QE2 proposes to add another $600 billion of excess reserves — but whether banks have $1 trillion or $10 trillion in excess reserves will have no impact.”

          In a message dated 11/19/10 17:53:48 Mountain Standard Time, writes:
          Jim (unregistered) wrote, in response to Edward Harrison:

          How can net financial assets not have increased when you’ve just created some out of thin air? You’re ignoring the fact that a bank doesn’t just end up with a Treasury bond on its books by magic. The Treasury doesn’t give them away for free. They had to be purchased first, with cash. That cash was in the economy, in the bank, then it was passed to govt in return for the Bonds, then was returned to the real economy by the govt when it used it to buy something, or pay out as welfare etc. After QE the Bank has as much cash as it had to start with, the Fed has the Bond, AND the initial money the bond was bought with is out there in the economy too. What am I missing?

          Link to comment: http://disq.us/shpl5

  14. David says:

    If I do a swap where I’m giving away “money” (zero interest liabilities with no duration) and I get treasuries in the 3-7 year duration range back as my asset, aren’t I basically increasing the duration of my portfolio and decreasing the duration of the other persons portfolio? So now the Fed is taking the duration risk while the banks are offloading it. If rates keep going down that’s good for the Fed. But if rates start going up doesn’t the central bank end up the loser in that arrangement?

    • Yes, the QE transfers duration risk onto the Fed. We should assume that the Fed holds to maturity of course so it really has no duration risk (unless it needs to sell assets to reduce its balance sheet instead of letting maturing assets run off). On the other hand, the banks do get to offload their own duration risk and that is helpful for their bottom line if yields back up.

      • David says:

        Even if they don’t realize a loss by holding to maturity isn’t the Fed accepting some kind of opportunity cost.

        Also, if we view the Fed and the treasury as one entity why can’t the treasury simply issue more low duration bonds rather then high duration ones. Isn’t the Fed’s QE doing the same thing by shortening duration of outstanding government liabilities.

        • Robert Rubin advocated reducing the Treasury’s duration when he was Treasury Secretary in order to reduce interest costs so this is something they can do. However, with interest rates low, it does seem wise to ‘lock in’ these rates now with longer duration from a risk management perspective. That is certainly what you see with the Mexican century bond.

          As far as the Fed’s opportunity cost in holding to duration, if you look at the Fed as a profit-maximizing organization, it is true that they could be foregoing yield. But I don’t see that as their function.

          Basically the Fed can create as many dollar credits as it wishes and buy as many bonds as it wishes, holding them to maturity without having to incur a capital loss. That is a central facet of fiat money, by the way – and a principal reason those talking about US sovereign default are off base.

          • David says:

            Let me elaborate. The Fed remits its “profits” back to the treasury, so you can think of it as one entity from the POV of the taxpayer. Any gains or losses by either entity ends up in the taxpayers hands.

            Whenever the treasury runs a deficit it creates an asset. Those bonds become an asset of the banks. The Fed can create assets as well; zero interest zero duration government liabilities called money.

            If the Fed trades money for longer duration bonds it is merely shortening the asset duration of the private sector. Thus, its removing interest rate risk from the private sector. When you talk about “locking in low rates” this action acts in total opposite to this goal. You are locking in short rates rather then long rates. You are limiting the potential gains to be had from monetizing the debt because the private sector is short, rather then long, duration.

        • What’s the “opportunity cost”? The Fed neither has, nor doesn’t have dollars stored in a lock box somewhere, so the idea of opportunity cost doesn’t apply. As Ed suggested, there is POLITICAL costs associated with theor actions, but that’s a distinct issue, which Ed has already covered well.

        • I understand what you’re saying about duration, but the Government is working at cross-purposes to itself. On the one hand the Fed wants to shorten duration by targeting longer-dated paper and replacing it with the equivalent of Treasury bills (money/dollar credits). Ostensibly, the objective is to drive down Treasury rates a la Operation Twist.

          But on the other hand, the Treasury does not necessarily want to shorten duration. There is still a residual concern in policy circles of rates backing up. Yes, this limits the gains from the Fed action. 100%. It makes QE all the more ineffective. If the Treasury and the Fed were acting in concert, the Treasury would be limiting its schedules of 5 or 10-year auctions and instead shortening duration as it had done under Rubin. I am not aware that it is doing so.

          It doesn’t seem that the Fed and the Treasury are acting in concert.