Why QE Isn't "Printing Money" and Hasn't Led to Inflation...Yet
It's evident that Yellen's approach to monetary policy is consequently the same as Bernanke's, and that QE is here for the foreseeable future. With that in mind it's time to explore the Fed's actions in more detail.
Talk to anyone on Main Street, Wall Street, or the media, and you'll constantly hear the phrase "the Fed's printing money." But talk to Bernanke himself, and he'll tell you with a straight face that the Fed is not printing money. Where does this discrepancy in interpretation come from?
Let's begin with this - the legal responsibility of printing currency in the form of physical US notes resides with the US Treasury, not with the Fed. All printing presses are owned and operated solely by the Treasury. In our modern economy, the need for physical notes is driven by consumer demand (to use as a medium of exchange), and the physical deterioration of existing notes. As of July 2013 there was approximately $1.2 trillion dollars of US currency in circulation - a tiny fraction of the actual amount of money in circulation.
It's more accurate to say that the Fed is "creating" money, not printing it. And to this statement Bernanke will nod his head in agreement. When the Fed creates money, it does so digitally by increasing the balances of the reserve accounts that are held at the Fed by its member banks.
[Read More: Fed Targeting 20,000 on the Dow]
I know what you're thinking - so the Fed is creating money not printing it, big deal. Well you're right, it's a matter of semantics. But therein lies the beginnings of substantial misunderstanding as to how the Fed's QE policy actually works.
In speaking with investors I hear time and time again that the Fed's relentless printing of money is increasing the supply of dollars, which will result in massive inflation, if not hyperinflation. There are problems with this simplified line of reasoning.
It may come as a surprise, but when the Fed creates money, this new money does not increase the amount of money in the economy (there are some minor exceptions to be detailed later). Instead, the new money increases the size of the Fed's balance sheet. The impact to the economy has to do with the composition of the money supply only. This claim demands more explanation so let's use the current $85 billion dollar per month QE program as an example.
When the Fed creates $85 billion, it uses this money to buy bonds - typically split 50/50 between US Treasuries and Mortgage Backed Securities (MBS). Here is what's important: When the Fed creates and gives $85 billion in reserves to its member banks, it removes $85 billion worth of assets (bonds) from the balance sheets of those same member banks. The result is that no new net financial assets enter the economy. This bears repeating. Every time the Fed injects $85 billion in reserves (assets) into the economy, it removes $85 billion worth of assets from the economy. This process is not a one way flow of money into the economy, as interpreted by some.
It's much more accurate to think of the Fed's QE program as an asset swap. In fact it's even more accurate to think of it as a liquidity swap. More on that in a minute. The important concept here is that every time the Fed creates money, that money does not increase the total money supply in the economy, it increases the size of the Fed's balance sheet. I'll go into more detail in another column, but the size of the Fed's balance sheet is not as important as many will argue because it effectively sits outside our economy (again with some exceptions).
As I mentioned, quantitative easing should be viewed as a liquidity swap. In this context liquidity refers to the ease with which money can be used. Think of it like this: Cash in your bank account can be used at a moment's notice to purchase goods and services, make an investment or be lent out. However, cash (in the form of equity) in your home, cannot be easily used for these purposes (you must sell your house or acquire a line of credit first). The cash in your bank account is highly liquid, but the cash tied up in your home is not.
Now let's take this understanding and apply it to the banks, the QE process and the money supply.
Note: Discussions on the money supply and the various "money aggregates," M0, M1, M2 etc. can quickly become complex. For the purpose of this article I'm going to keep things simple and we'll get into the specifics later.
A diagram may help convey the actions taking place through quantitative easing. In the picture below, the whole pie represents the total money and credit supply (the two are basically interchangeable) in the economy. The blue area represents low liquidity money and credit (such as bonds, IRAs, 401Ks etc.) and the yellow area represents high liquidity money and credit - which is the portion of the total money supply that is immediately available for lending, investing or to chase goods and services.
The important thing to understand is that money that is not liquid (the blue area) cannot easily be lent, and it cannot easily be spent - the two critical pillars to driving economic growth. That money is effectively "tied up." When the Fed engages in QE, it is taking bonds (low liquidity instruments which reside in the blue area) and it is exchanging them for cash reserves, which can be lent and/or used to purchase assets. Cash reserves are part of the yellow area (high liquidity). This means that the high liquidity component of the money supply is growing in relation to the low liquidity portion, but the total money supply does not grow. The way the total money supply in the economy grows is through bank lending - a function of our fractional reserve banking system and the subject of a separate column.
To summarize: The economy grows through investment, spending and consumption. Quantitative easing is a process by which low liquidity instruments (bonds) are replaced with high liquidity cash reserves. These new cash reserves are available to banks for lending - which drives investment, spending and consumption, or they can be invested - which drives the capital markets higher. Even though the Fed is creating money each month, this money winds up on the Fed's balance sheet in the form of bonds. From the economy's perspective all that happened was an exchange of low liquidity assets to high liquidity assets - assets which if lent or spent, can now help fuel economic growth.
QE has potentially severe implications for inflation, but not directly from the QE itself. Instead the inflation will come as a result of a dramatically increased total money supply resulting from bank lending. QE does enable more bank lending, but the lending must take place for the total money supply to grow. A follow-up to this column will examine bank lending in more detail. For now, I will leave it at this: Bank lending is dismal, which is why the total money supply has not increased as much as anticipated. The money which the Fed is making available for banks to lend is not being lent out, and is instead working its way into asset prices and accumulating in the reserve accounts of member banks. If and when that money begins to flow out as loans - then we will need to be acutely aware of inflation showing up on our doorstep.
Lastly, the other goal of QE is to keep long-term rates down (through bond purchases), which further helps to increase lending and consequently investment, spending and consumption.
I've greatly simplified this explanation and left many rocks unturned for the sake of time and space - we will explore these further and in more detail down the road. I figured this was a good place to start. If you have any questions or need clarification, don't hesitate to shoot me an email and I'll try to address in future remarks.
The following is an excerpt of Richard Russell's Dow Theory Letters. To receive their daily updates and research, click here to subscribe.
About Matthew Kerkhoff
Matthew Kerkhoff Archive
|04/15/2015||Economic Uncertainty Driving Corporate Buybacks?||story|
|04/13/2015||Which Is the Greater Threat to Investors – Inflation or Deflation?||story|
|04/06/2015||Market Outlook: Cautiously Optimistic||story|
|03/31/2015||Expect Volatility With First Decline in Corporate Earnings in Three Years||story|
|03/24/2015||Fischer: Fed Going From “Ultra Expansionary” to “Extremely Expansionary”||story|
|03/10/2015||How Relevant are the Dow and Dow Theory?||story|
|03/05/2015||Corporate Buybacks at Record Levels||story|
|03/03/2015||Don’t Sweat Nasdaq 5000||story|
|02/26/2015||Oil Price Collapse: Supply or Demand?||story|
|02/10/2015||The Case for Small Caps||story|