March 11, 2012
Sterilized quantitative easing
Jon Hilsenrath of the Wall Street Journal reported last week that Federal Reserve officials are evaluating the possibility of a measure that the journal describes as "sterilized" quantitative easing. How would this work, and what would it be intended to accomplish?
From the Wall Street Journal:
Federal Reserve officials are considering a new type of bond-buying program designed to subdue worries about future inflation if they decide to take new steps to boost the economy in the months ahead.
Under the new approach, the Fed would print new money to buy long-term mortgage or Treasury bonds but effectively tie up that money by borrowing it back for short periods at low rates. The aim of such an approach would be to relieve anxieties that money printing could fuel inflation later, a fear widely expressed by critics of the Fed's previous efforts to aid the recovery.
To understand what this means, let's begin by looking at the consolidated assets of the Federal Reserve. Traditionally, the primary assets of the Fed were just Treasury securities, as seen in the blue area on the graph below. During the financial crisis in 2008, the Fed extended a series of emergency loans in the form of currency swaps, the Commercial Paper Funding Facility, the Term Auction Facility, and a host of other new lending program, as indicated by the orange region. As financial concerns eased, the Fed replaced these emergency loans with large holdings of mortgage-backed securities, maintaining its total assets at the new high levels. The Fed made a subsequent decision to expand its holdings of longer-term Treasury securities in November of 2010, in what came to be popularly referred to as a second phase of quantitative easing, or QE2.
Alternatively, one can look at the liabilities side of the Fed's balance sheet, whose total value at each date is by the nature of double-entry accounting exactly equal to the value of the Fed's assets. Traditionally, the Fed's principle liability consisted of publicly circulating currency (dark green in the graph below). For this reason, the Fed's purchases of Treasury securities are often popularly described as being paid for by "printing money". However, very little of the Fed's expanded operations since 2008 have been financed in this way. Instead, the main growth in the Fed's liabilities has come in the form of reserves held by financial institutions in accounts with the Fed.
Although currency may not be a true liability of the Fed in other than the double-entry accounting sense, reserves function much more like a conventional liability. For one thing, banks could at any time ask to convert these credits into green cash. If the present huge quantity of reserves were to end up as currency in circulation, the result would be highly inflationary, and the Fed would need to sell some of its assets or take some other action if it wanted to keep that from happening. Moreover, the Fed pays a 0.25% annual interest rate on reserves that banks keep on deposit with the Fed overnight. In effect, what the Fed has been doing since the fall of 2008 is borrowing by means of rolling over 1-day loans (that is, by means of interest-paying reserves) and using those funds to make emergency loans, buy MBS, or buy longer-term Treasury securities.
As these programs were implemented, there was considerable discussion of the Fed's "exit strategy", which referred in part to how it would prevent the reserves from ending up as circulating currency. Selling off its assets would be one option, but that might be more contractionary than the Fed would want to be in a weak recovery. Two years ago, Chairman Bernanke discussed the following alternatives:
One such tool is reverse repurchase agreements (reverse repos), a method that the Federal Reserve has used historically as a means of absorbing reserves from the banking system. In a reverse repo, the Federal Reserve sells a security to a counterparty with an agreement to repurchase the security at some date in the future. The counterparty's payment to the Federal Reserve has the effect of draining an equal quantity of reserves from the banking system....
As a second means of draining reserves, the Federal Reserve is also developing plans to offer to depository institutions term deposits, which are roughly analogous to certificates of deposit that the institutions offer to their customers. The Federal Reserve would likely auction large blocks of such deposits, thus converting a portion of depository institutions' reserve balances into deposits that could not be used to meet their very short-term liquidity needs and could not be counted as reserves.
As Bernanke noted, repos and reverse repos are quite traditional tools that the Fed has always used when it wanted to add or drain reserves on a temporary basis. Rolling over 28-day reverse repos, or auctioning 28-day term deposits to banks, would be one way to give the Fed a bit more management control over the liabilities it has created.
In effect, the Fed is currently funding its asset purchases by borrowing overnight, whereas under the new proposal it would do more of its borrowing with 28-day loans.
What difference does it make whether the loans are for 1 day or 28 days? Does it matter, as the Wall Street Journal suggests, for inflation expectations? I'm having a little trouble seeing why it should. Some analysts may worry about the mechanical and logistical challenges of managing the large volume of reserves as conditions change, and perhaps the proposal could relieve this concern somewhat. It may convince others that the Fed does not intend to allow its expanded balance sheet to end up in the form of circulating currency. The Fed might also worry that simply the announcement of expanding dependence on term deposits or reverse repos by itself might be mistakenly construed by the public as a signal that the tightening cycle has begun. A proposal of simultaneously announcing some new asset purchases funded by term borrowing could get the new borrowing regime up and running without sending the wrong signal.
More fundamentally, one might ask what good does it do for the Fed to borrow short and lend long? The net effect should be to put downward pressure on long-term rates in the hopes that this might boost home purchases, help households strengthen their balance sheets with refinancing, and encourage investment and net exports. A realistic assessment I think would say that the effects of borrowing short and lending long are likely to be pretty modest, particularly given that the U.S. Treasury has been issuing long-term debt faster than the Fed can buy it. My conclusion is that measures such as QE2, insofar as they had an effect, operated primarily as a tool the Fed can use to punctuate its declarations of near- and longer-term policy objectives.
And I'm inclined to form the same judgment about sterilized QE3.
Posted by James Hamilton at March 11, 2012 07:46 AMdigg this | reddit
I am confused. Is this strategy designed to keep long term rates from sky-rocketing if the economy heats ups (by keeping long term bond/MBS prices low)? Or, is it a strategy to keep banks solvent ( by infusing banks with new money and then paying them interest to borrow it back) in case the economony tanks?
Posted by: tj at March 11, 2012 09:13 AM
Nice explanation. I get the sense that there are all kinds of ways in which things could go wrong in the direction of inadvertently sending a contractionary signal to the economy, but not too many ways in which the Fed could use a sterilized QE3 as an expansionary tool. So there's a kind of asymmetry of likely outcomes. Is that right or am I misunderstanding you?
If the economy improves significantly and homeowners that are currently underwater are able to repair their balance sheets such that foreclosures start to fall off, then I take it that the market value of the Fed's MBS holdings will increase. So shouldn't that increase the Fed's ability to drain reserves in the future because those MBS holdings will be able to leverage more cash?
Posted by: 2slugbaits at March 11, 2012 09:42 AM
To focus on one line: "If the present huge quantity of reserves were to end up as currency in circulation, the result would be highly inflationary, and the Fed would need to sell some of its assets or take some other action if it wanted to keep that from happening."
Is it me? I can't see the Fed allowing this to happen. That would be a total abrogation of its duties under law and of its self-image. I keep hearing this - from many places - as though the Fed would sit on its hands as mega-billions were suddenly shoved into circulation.
I also see much of what the Fed is talking about - particularly the Bernanke quotes - as more about bookkeeping than fiscal policy.
But in the end, I agree with the main point, that extending the rollover term is a signal. I don't see it having much impact on long term rates - unless they're doing stuff further out on the curve - but I do see it as signaling they're thinking about how to clean up the balance sheets.
Posted by: jonathan at March 11, 2012 09:52 AM
Bit of a leap of reasoning here:
"For one thing, banks could at any time ask to convert these credits into green cash."
Sure they could. So, far so good.
"If the present huge quantity of reserves were to end up as currency in circulation, the result would be highly inflationary, and the Fed would need to sell some of its assets or take some other action if it wanted to keep that from happening."
Woah! Where did that come from? Why have we suddenly gone from banks turning reserve balances into notes to these notes entering circulation. There seems to be a logical step missing here.
Of course, its the same logical step that ALL misconstructions of how the banking system actually operates misses. Making many of these discussions completely redundant.
Posted by: Philip Pilkington at March 11, 2012 09:59 AM
Isn't that payment of a 0.25% rate on reserves the "healing" part of this scheme? If so, when that rate climbs to 1%, couldn't the Fed reduce those reserves to 1/4 of its current size to get the same amount of "healing"? And, at that time, won't the economy be healthy enough that less "healing" is required anyway?
Isn't this just another "non-event" that the press and whackos like to babble about?
Posted by: xls5929 at March 11, 2012 11:08 AM
If it is a non-event, why bother?
Posted by: KevinM at March 11, 2012 12:26 PM
Forgive me, but this concept makes me think of decaf coffee: use only when there is no other choice!
Posted by: Becky Hargrove at March 11, 2012 02:52 PM
sounds like running a hamster wheel hoping to get somewhere. Low interest rates are not the problem, they are the symptom. The Fed needs to get ahead of the curve, by committing to a proper course like QE 3 until inflation AND UE (including labor force participation) are well on the their way towards their targets. Now is the time for a little surprise announcement, when it would gain the most traction, to get the economy out of the muck.
Posted by: dwb at March 11, 2012 04:20 PM
Is it just a question of preventing inflationary money supply growth? Perhaps this is just one factor. Potentially just as important is the return of collateral to the repo market. A proper functioning of this important market may become difficult if the Fed continues to accumulate a lot of the most liquid collateral via QE. Releasing this collateral back into the market may be one way to ensure adequate private sector finance flows.
Posted by: Mark Tierney at March 11, 2012 04:27 PM
Financial fiddling would be much more effective if we had a closed economy - or a least some control over money flows in and out + goods flows in which takes money out.
Posted by: ReformerRay at March 11, 2012 06:25 PM
I don't understand those that think QE to inflation is the solution. Jobs and rising wages are the solution. Banks won't lend and borrowers won't borrow until they think they can make money. They won't think they can make money until there are customers with money willing to spend it. Thus they can't make money until there are jobs. The private sector won't create jobs thus this will have to fall on the gov. Of course in the US and Europe we have stalemate or the austerity message has won. I don't see much hope for this ending well.
So far QE has ended up in the hands of speculators who have driven up the price of food and fuel. The consumer now has less money to spend on manufactured goods and services. The current bubble will pop just as the last ones has.
Posted by: measton at March 11, 2012 10:00 PM
The central banks may find a scarcity of buyers on the long term yields curves and rare they will be .Sovereign countries are showing a decreasing current accounts, China has posted a trade deficit mainly due to oil price increase and commodities markets manipulation. The Fed in its wisdom is mainly owning the short dated bonds issues. very little of the belly and less of the long term issuance.For more details please read:
"The Great Repression: Freedom of Speech in the Bond Market" Global Macro Monitor
The natural falls back are the financial institutions, Central banks would be catering for their fundings when lending them the maturities, funds and interest rates,no mismatch is involved. A concept and not a reality, Banks are always trying to be more intelligent when guessing the canvas of the world yields curves,treasury assets liabilities management.It may involve currencies, carry trade,interest rates swaps and in fine when things turn for the worse calling on depositors moneys and central banks lenders of last resort mandates.Would Basle 3 be the provider of a better police,No if derivatives are loosely defined as constraints on the all operators balance sheets.Note as well, that balance sheets risks weighing,are predicated upon the quality of the assets as conveniently rated by the rating agencies and conveniently refuted in the worse case scenario.
Would arbitrage be possible,currencies ,yields curves,Yes unless one size policy and country yield curve fit them all.
Blomberg: "Financial Repression Back to Stay: Carmen M. Reinhart"
The real estates a main beneficiary,in France the market is shared between the Thenardier (Les Miserables V. Hugo) and the Rougon Macquart(E.Zola), markets are closed to the others,the same all over Europe. The banks distribute dividends, bonuses,increase their capital by few billions and manage trillion of well performing assets?
We have read Orwell,Aldous Huxley, V Hugo,E. Zola, and yet not much about the evolution of the Hamsters.
Posted by: ppcm at March 11, 2012 11:43 PM
I paused at the same place in the discussion that Philip Pilkington, above, stopped at -- why transferring reserve balances from Bank A to Bank B (what Bank B would do with those greenbacks it got from its customer who got them from Bank A's customer who got them from Bank A) would be inflationary.
Is there something here about the Fed losing control of the short-term interest rate which is the issue? I'm perplexed.
Posted by: Ellen1910 at March 12, 2012 12:06 AM
Thanks you professor. I was beginning to think I was one of the few who heard the Bernanke say this. To rephrase your conculsion this is essentially the FED chasing its tail. "Snow" Bernanke and his dwarfs have announced that they are essentially out of ideas and that they will continue there current non-policy of keeping interest rates low. So as not to appear irrelevant and to keep their faces on the news they must do something so they have come up with another scheme of chasing their tails.
But there is another outcome. Keeping interest rates low favors the rich with money not the poor who have lost their homes, but sadly it nearly forces the rich to invest their money in assets that are not productive and do not create jobs. Once again we see FED following government actions to give welfare to the rich while depressing the poor even more.
It is just another example of the self-proclaimed, all-knowing autocrats ruining the lives of the average man with their foolish games. Sudoku anyone?
Posted by: Ricardo at March 12, 2012 05:54 AM
The transformation,currencies,assets,liquidities is the key issue.
The banks balance sheets are not only deployed in the USA or in Europe and not all banks have the same opening ,exposure to the international flows of funds.
A domestic bank may have surplus of funds that are lent to an international bank,it will fall into the balance of funds in currencies of the international bank and deployed in accordance to the opportunities and needs of the time,with no question asked by the creditor.The liquidity ratios are only to be met at time of monthly reporting,in between assets opportunities are the drivers.It is worth knowing that window dressing occur at time of reporting through repo s, Bank A may take in pension for 24/48 hours the excess of assets of Bank B or vice versa.
Cumulatively the largesse of the central banks will not fine tune risks,flows of funds,bubbles my neighbor policies.It is bad practice to lend three years bullet loans to debtors and to ask them three years after to repay.Moreover central banks do not show a strong record of assets risks management.
Posted by: ppcm at March 12, 2012 07:24 AM
I was always worried that the exit strategy will not work properly. And after reading your post James, I am quite sure that it will not work : Bernanke has no idea what to do and when to do it, he is just trying like a modest poker gambler .. good luck then.
No offence to Bernanke, the system became to complex and interconnected after the establishment of Greenspans fantastic new financial instruments... chaotic dependencies are the result.
Posted by: Johannes at March 12, 2012 11:13 AM
How is the "sterilized QE" different from their current "twist-operation" ? Even under the twist-operation, their balancesheet has been maintained the same, as they sell short-dated UST to finance purchases of long-dated ones. Is the difference that they will use the reverse-repo or term deposit instead of selling short-dated UST ?
Posted by: TK at March 12, 2012 05:29 PM
Dr. Hamilton, my memory might be wrong, I thought you mentioned a relationship with the increase in delivery of WTI by train and truck with gasoline prices, but I haven't been able to find it. Did you find a relationship with gas prices?
Posted by: aaron at March 13, 2012 09:19 AM
Mr. Friedman told us that reserves at the Federal reserve Banks are money. I will cling to that idea, in his memory.
Posted by: Fat Man at March 14, 2012 10:40 PM
When will we get it.I know when I was talking about this 25-30 years ago,they thought I was referring to some Nazi science project. Watch,you'll see.
Posted by: George B. Kottis at April 1, 2012 06:47 PM