QE’s like the Batman:
Most don’t know what lies underneath, and those who do don’t talk much about it. But when we look closer, it’s pretty clear that the sick jawline gives it away.
I don’t know whether the divide over-explaining QE lies in misunderstanding, or in deliberate attempts to distort information. Regardless, let’s evaluate some common claims about QE.
Claim #1: The Federal Reserve prints dollars.
Not really. The Fed does not literally print anything — technically, everything’s being done on a keyboard. You may then say “OK, so the Fed creates dollars?”
No — they don’t create dollars either. They create bank reserves (out of thin air). What are reserves? It’s useful to think of reserves as “bank money”. Commercial banks are free to lend reserves to one another, but these reserves don’t really go into circulation in the economy.
Claim #2: Whenever the Fed purchases assets using newly created bank reserves, it’s engaging in the unconventional policy tool called Quantitative Easing.
False. Actually, the Fed purchases assets using newly created bank reserves all the time. It does this via “Open Market Operations”. So what differentiates QE from Open Market Operations? QE happens when short-term interest rates are already pretty low. There’s not much room to push them even lower. So we want QE to reduce interest rates in the long term (more on the mechanics that lead to this later).
So 2 things differentiate QE from Open Market Operations: 1) the type of assets being purchased and 2) the quantity of reserves being created to be injected into the economy.
Namely, the Fed creates a much larger quantity of reserves than usual and then buys longer-maturity bonds (where the debtors have more time to pay off their loans). This is the Fed’s attempt to ultimately lower longer-term interest rates.
So the Fed purchasing assets using reserves doesn’t always equate to QE — these 2 added characteristics are what elevate Open Market Operations to QE.
Claim #3: Bank reserves are injected directly into the economy.
This statement is an oversimplification. The Fed creates reserves, which it uses to purchase specific types of assets from Primary Dealers (generally Commercial Banks). Hence the reserves are swapped for other assets. So at the end of the day, the Fed doesn’t just create reserves and throw them into the economy. Instead, the Fed throws reserves into the banking system and now owns the assets it bought from the banks.
There has been an addition (reserves) and a subtraction (assets).
Claim #4: Commercial Banks are the ones who create money, not the Fed!
Strictly speaking, this is true. But it’s also somewhat misleading.
Firstly, contrary to popular belief, the idea of fractional reserve banking taught in textbooks is detached from reality. (It’s basic idea is that banks lend out portions of their customers’ savings.)
False — in reality, saving does not create lending. In fact, it is vice versa.
What actually happens is closer to this:
Let’s assume Bank A has $0. Sam goes to Bank A and asks for a loan of $100. Bank A thinks that Sam is likely to pay back the loan with interest. Bank A creates $100 out of thin air and lends this $100 to Sam.
But for every $100 that the bank lends, it needs to safekeep a fraction of that in reserves (let’s call them reserve dollars). Let’s say the fraction is 10%.
So for Bank A to lend $100, it needs 10 reserve dollars.
This is where it becomes clearer that by creating reserves and injecting them into the economy, the Fed can increase the speed at which banks can potentially create money. So you could phrase it that by creating reserves, the Fed is indirectly allowing for the creation of more money than would’ve been without QE.
Hence I’d argue that yes — the Fed can indirectly create dollars via QE.
(Now whether more dollars actually get created from increased reserves, by banks lending money is a different ballgame. We’ll save that for another letter.)
Side-note: To those who’d argue that banks never really face a reserve constraint because the Fed will supply whatever extra is required at any point in time — I agree! But it doesn’t change the fact QE can create more dollars over time than there would’ve been without it.
Claim #5: QE’s just a huge placebo meant to trick everyone into thinking that there’s gonna be inflation. Hopefully, everyone buys this trick and spends their dollars now, before the dollar’s purchasing power falls.
Firstly, it’s hard to gauge whether QE will result in inflation — it really depends on the context under which it was employed and how much of the reserves actually translated into dollar creation. It’s even harder to judge is when exactly inflation will hit (if it hits).
As demonstrated above, there are clear mechanics that can result in economic stimulation and potentially inflation. A placebo could be part of what’s stimulating the economy or creating inflation. But citing it as the sole factor isn’t a convincing argument.
Hopefully, it’s a bit clearer now that underneath that mask lies Bruce Wayne. Whether he has serious issues is stuff we’ll be exploring in future letters.
Till then,
Ja ne!
I created this newsletter to share, get roasted, and learn along the way. So if there’s anything you feel that I got wrong, or you’ve feedback in general, do let me know in the comments or DM me on Twitter!
Thanks for reading the first letter, and I hope you have a great week ahead!
P.S. If you’re interested, I highly recommend checking these out:
https://www.hks.harvard.edu/sites/default/files/centers/mrcbg/programs/senior.fellows/2019-20%20fellows/BanksCannotLendOutReservesAug2013_%20(002).pdf
https://www.fxstreet.com/analysis/its-all-lies-part-1-the-fed-isnt-printing-money-202106091300#:~:text=Now%2C%20notice%20the%20three%20channels,(more%20on%20this%20later).
https://www.quora.com/Why-does-the-Fed-buy-treasury-bonds-through-the-open-market-instead-of-directly-from-the-treasury
https://www.federalreserve.gov/pubs/feds/2010/201041/201041pap.pdf
https://elischolar.library.yale.edu/cowles-discussion-paper-series/388/