John Kemp: Quantitative easing has begun


By John Kemp
Friday, November 14, 2008

Quietly, without fanfare, the Federal Reserve has turned on the printing presses. The central bank is flooding the market with enough excess liquidity to refloat the banking system -- and hopes to generate an upturn in both economic activity and inflation in the next 12-18 months to prevent the economy falling into a prolonged slump.

Since the banking crisis intensified in September, the Fed has been rapidly expanding the credit side of its balance sheet, providing an ever-increasing array of facilities to support the financial system (repos, term auction credit, primary discount credit, broker-dealer credit, commercial paper funding, money market mutual fund liquidity and term securities lending).

Total credit extended by the central bank has surged from an average of $885 billion in the week ending August 27 to $2.198 trillion in the week ending November 12. Credit extensions surged another $142 billion last week alone -- mostly in form of increased term auction credit (+$114 billion) and other miscellaneous credits the central bank does not break out (+$41 billion).

Until fairly recently, the expansion on the asset side of the Fed’s balance sheet was matched by increased non-bank liabilities, mostly in the form of higher balances deposited by the US Treasury into its regular and special supplementary financing accounts at the central bank.

Since the Treasury was borrowing this money in the open market by issuing cash management bills, the impact of the Fed’s balance sheet expansion was being fully sterilized.

The Fed was providing liquidity in the narrow sense (helping commercial banks cover short-term funding problems arising from illiquid assets on their books) but not in the broader sense of inflating the money supply (money in circulation plus vault cash plus reserve balances).

But in the last three weeks, something very significant has happened. The non-bank part of the Fed’s liabilities has stopped expanding: combined Treasury deposits with the Fed plus cash in circulation has actually fallen from $1.517 trillion in the week ending Oct 29 to $1.467 trillion in the week ending Nov 12.

Instead, the Fed’s increased lending to the financial system over the last two weeks (+$325 billion) has been matched by an increase in the volume of deposits the commercial banks are hold with the Fed (+$331 billion).

In other words, the Fed is now lending to the banks, which are now lending the funds back to the central bank. The Fed is no longer supplying just narrow liquidity needed to enable the market to function. It is now supplying excess funds (more than the banks need) which are being recycled back into the central bank.

The volume of reserve balances with the Fed, which had jumped from $8 billion at end Aug to $280 billion by mid Oct, has now surged again to a staggering $592 billion in the week ending Nov 12.

The Fed is now very deliberately supplying more liquidity than the banks need (or are willing to lend on to other banks, corporations or homeowners). By paying a low but positive interest rate on these reserve balances, it can ensure that the federal funds rate remains above zero (currently about 35 basis points) even as it floods the banking system with excess funds.

There are several startling implications:

(1) The central bank has successfully driven a wedge between interest rate policy (the target fed funds rate) and the quantity of money created (cash plus reserve balances). This was the explicit aim, foreshadowed a recent paper by the Federal Reserve Bank of New York ( 4n2/0809keis.pdf). The Fed is now free to expand bank reserves almost without limit while maintaining the fed funds target (at least very loosely).

(2) The Fed's focus has now shifted from easing the interest rate to increasing the quantity of money, and the aim of supplying funds is no longer to ease concerns about narrow liquidity but to increase the overall money supply, thereby easing concern about the stability of the banks, while hoping to engineer an eventual upturn in lending, activity and (whisper it quietly) inflation.

This is precisely the radical strategy adopted by the Bank of Japan in the late 1990s and early part of the current decade, when it was described as "quantitative easing." Fed Chairman Ben Bernanke, a keen student of liquidity traps during the Great Depression and Japan's decade long banking and economic slump, threatened some time ago that the Fed could always increase the quantity of money by manipulating the size and composition of its balance sheet.

In a 2004 paper Bernanke noted: "Nothing prevents a central bank from switching its focus from the price of reserves to the quantity or growth of reserves. When stated in terms of quantities, it becomes apparent that even if the price of reserves (the federal funds rate) becomes pinned at zero, the central bank can still expand the quantity of reserves. That is, reserves can be increased beyond the level required to hold the overnight rate at zero -- a policy sometimes referred to as 'quantitative easing.' Some evidence exists that quantitative easing can stimulate the economy even when interest rates are near zero; see, for example, Christina Romer's (1992) discussion of the effects of increases in the money supply during the Great Depression in the United States."

Bernanke argues that quantitative easing may affect the economy through at least three channels:

(1) Large increases in the money supply will lead investors to rebalance portfolios, reducing yields on other non-money assets, stimulating investment, consumption and other economic activity.

(2) Setting a high level of reserves and committing to maintain it until certain (economic) conditions have been fulfilled is an alternative and perhaps more visible and credible way to stimulate growth and promising to maintain a low interest rate.

(3) By expanding its balance sheet and replacing public holdings of interest-bearing government debt with non-interest bearing (or very low interest) money and reserves, the central bank may attempt to hold down yields on a range of government securities, making borrowing cheaper, and cutting the costs of an expansionary fiscal policy. The strategy works if and only if the central bank can pre-commit not to reverse the quantitative easing policy for some considerable period and until certain conditions have been met.

Bernanke went on to note: "The forms of monetary stimulus described above can be used once the overnight rate has already been driven to zero or as a way of driving the overnight rate to zero. However, a central bank might choose to rely on these alternative policies while maintaining the overnight rate somewhat above zero."

Moreover, alternative monetary policies such as quantitative easing could enable the central bank to avoid the problem that nominal interest rates cannot readily be cut below zero: "A quite different argument for engaging in alternative monetary policies before lowering the overnight rate all the way to zero is that the public might interpret a zero-instrument rate as evidence that the central bank has 'run out of ammunition.'"

That is, low rates risk fostering the misimpression that monetary policy is ineffective. As we have stressed, that would indeed be a misimpression, as the central bank has means of providing monetary stimulus other than the conventional measure of lowering the overnight nominal interest rate. Since the middle of October, the Federal Reserve has begun to put precisely this strategy into practice.

Quantitative easing has begun.

Bernanke once threatened to send in the monetary helicopters if that was necessary to avoid deflation and a renewed Great Depression. The massive surge in bank reserves in the past fortnight suggests the helicopters have now been scrambled and the strategy is being put to the test.


John Kemp is a Reuters columnist. The views expressed are his own.

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