Central banks typically conduct monetary policy through control of short-term interest rates. As short-term interest rates approached zero in late 2008/early 2009, concerns grew that central banks would be helpless. But central banks had other tools which they could use. One such tool was quantitative easing (QE). QE policies are those that unusually increase the monetary base, including asset purchases and lending programs. Programs designed to improve credit conditions (credit easing) are a special case of QE if they also increase the monetary base. This is the form of QE pursued in the US.
Many people have misconceptions of how QE actually worked. They think the Fed printed money and bought bonds. In theory, this is correct — but in practice, not quite.
To explain, the Treasury sells debt to help fund our deficit and ongoing needs. (It is important to note that the Fed and the Treasury are two separate entities of the US government.) Primary dealers, large banks that deal directly with the Fed, buy this debt along with other securities such as mortgage-backed securities. The Fed buys bonds from the Primary dealers and pays for them by electronically depositing funds in the bank’s reserve account at the Fed. (The Fed requires that banks hold ~10% of deposits either in cash in the bank’s vaults or at the local Federal Reserve Bank. Reserves greater than this amount are called excess reserves.) In theory, the electronic deposit is “printing money,” but it still needs to get into the economy.
The banks now have a choice: lend out these new funds or keep them at the Fed as excess reserves at an interest rate that the Fed pays. The Fed in reality is borrowing money on a short-term basis and investing it at a higher rate and a longer term. The large scale purchases by the Fed keep interest rates low and force investors into other higher yielding assets.
The theory for this type of QE to work is for the banks to lend out these reserves. Through our fractional banking system, banks can convert excess reserves into bank loans at about a 10-to-1 ratio. Once in the economy, the electronic deposit becomes “money.” Prior to June 2008, the amount of excess reserves was very steady at ~$2 billion. From the moment of the first QE program, this figure began to skyrocket. Today it stands at $2.25 trillion. So, as the Fed’s balance sheet grew from $1 trillion prior to the recession to today’s $4.5 trillion, 64% of it did not make its way into the economy.
The banks have multiple reasons for not lending out these funds, with one strong reason being increased regulatory requirements dictated by the very same Federal Reserve. A good analogy for this is the Fed is driving a car with one foot on the gas and the other on the brake.
The Fed just announced that it is going to begin decreasing the amount of re-investments from maturing principal and interest payments from the bonds it owns. As our Chief Investment Officer pointed out in the last blog post, it was called quantitative easing when they were buying bonds, so this can be called quantitative tightening. In theory, the Fed should be able to withdraw the excess reserves from the financial system before borrowers feel the impact. In reality, time will tell how this action will affect interest rates. What we do know is that the amount of debt to finance the government (Treasury) will not decrease, so a different source of demand will be needed and this source may demand higher rates.
Brian is a Vice President and Senior Portfolio Manager who manages the fixed-income investment process for Wealth Management & Advisory Services clients by providing sophisticated investment counsel and portfolio risk control strategies. Brian is the bank’s primary fixed-income strategist and oversees the strategy, implementation and trading of all fixed-income securities for both private and institutional capital. Brian also holds a Chartered Financial Analyst designation. He has more than 20 years of portfolio management and institutional investment experience. Brian's significant expertise in fixed income is a key to our clients’ financial success, as he positions them to both safe and well positioned portfolios.