The purpose of this post is to bust some common myths about the essence of Quantitative Easing (QE). Failure to understand how some monetary policy tools work leads to thoughtlessly quoting oversimplified journalistic clichés like: “The Fed cranks up its printing press”, mixed with “gigantic US Debt”. You get the idea 🙂

So, let’s clarify the essence of QE a bit by diving right into the technical stuff.

QE is not printing money or flooding the economy with liquidity (to the extent that we can talk about it on the scale of the whole economy), it’s merely an asset swap. For example, a treasury note for bank reserves (if we’re talking about the deal between a commercial bank and the Federal Reserve).

Consider a simple operation of QE (Fed buys Treasury note from a commercial bank):

Fed Balance:

Assets: + Treasury note
Liabilities: + Reserves

Balance of a commercial bank:

Assets: + Reserves (the deposit of the commercial bank with the Fed)
Assets: – Treasury note

What happened with the balance sheet of the commercial bank? One asset was swapped for another asset.

Now, consider another operation of QE with other agents from the private sector.

Private investor:

Fed Balance:

Assets: + Treasury note
Liabilities: + Reserves

Private investor:

Assets: -Treasury note
Assets: + Deposit

Investor’s commercial bank:

Assets: + reserves
Liabilities: + deposit

As can be seen in both cases, QE doesn’t alter the net worth of the private sector but changes the composition of assets. We can also notice that QE shortens the portfolio duration for banks, which has some benefits (like reducing duration risk). Now, two questions remain: where does the Federal Reserve get reserves to buy Treasury notes and, how does a change in the composition of assets of a commercial bank affect the process of money creation?

The answer to the first question is somewhat counterintuitive – the Federal Reserve takes reserves out of “thin air”. But, I note that there is no contradiction in this – the debtor (Central bank) can freely generate liabilities without a threat to its solvency if those liabilities are irredeemable and people around are ready to accept them.

What happens when the Fed increases Treasury “purchases” from the market? Banks get a lot of excess reserves (see the example above), i.e. the supply of reserves on the interbank market rises, and the rate (yes, it is exactly what federal funds rate is) starts to decline. Excess reserves are needed by banks for various reasons, including for lending.

Now about the process of money creation. To answer it, let’s consider some theory about monetary aggregates. For the US:

M0 – Paper money + coins
MB – Paper Money + Coins + Bank Reserves in the Fed Accounts
M1 – M0 + demand deposits + travelers checks + check deposits

MB is the monetary base, M1 is the money supply. When talking about inflation of the money supply (the notorious “printing money”), people mean inflation of M1. QE, as you can see, affects mainly MB, i.e. increases reserves of commercial banks in accounts with the Fed.

The growth of money supply (M1) is instead driven by other factors, mainly due to growth of demand deposits. And, how do they grow? By the growth of loans.

When the bank issues a loan, it creates corresponding demand deposit on the liabilities side, the funds from which the borrower will then use. Another question begs here: when does the moment of inflation of the money supply occur? When the loan spent returns into another bank as a deposit or at the time of issuing the loan when a corresponding deposit is created for it? I think in the first case.

But does QE contribute to credit growth? And what does it even contribute to? This is the topic of the next article.

Disclaimer: The material provided is for information purposes only and should not be considered as investment advice. The views, information, or opinions expressed in the text belong solely to the author, and not to the author’s employer, organization, committee or other group or individual or company.

High Risk Warning: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 73% and 70% of retail investor accounts lose money when trading CFDs with Tickmill UK Ltd and Tickmill Europe Ltd respectively. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

Share this post: