A Quick Note on Quantitative Easing- The Portfolio Composition is More Important than the Reserve Levels.

So I was recently engaged in a debate with a close friend of mine over what the repercussions of continued Quantitative Easing (QE) would be, and what the inflationary effects of QE would be. The debate began with agreement, with both of us acknowledging that the current program was largely ineffectual due to the huge amount of excess reserves in the US financial system. Differences did soon become apparent however when my friend expressed his concern over the inflationary effects of the program if it went on indefinitely. This was because of the difficulties of retracting the program if it were allowed to go on for too long. Retracting $2 trillion dollars is easier than retracting $20 trillion. With the reserves just sitting there in huge excess, surely Bernanke could taper the constant injections, but leave the money already there as is. Money at the moment is just sitting in the system floating about, so what’s the point of putting more in if it just makes the retraction harder? Surely the huge monetary base would keep liquidity high and interest rates low across the board. There is so much excess, why do we need more? Stop the program, leave the reserves there, and lending growth should be unchanged. The analogy is “If the shops can’t sell 10 apples, giving them 100 isn’t going to help them sell any more if the price doesn’t change”. And in other words again, people seem to think that as the money multiplier declines banks ‘park’ their money with the Fed, and do not ‘Lend it out’

This line of thinking however overlooks the actual mechanisms that drive the operations behind QE, and its theoretical framework. The fact is that QE works to drive specifically Long-term interest rates down with the purchase of Long-term assets. The answer lies in the fact that banks have strict portfolio norms that they follow, and that reserves don’t simply get “lent out”.

So let’s briefly address the “Lending-Out Misconception” first. This common misconception holds that when commercial banks hold too much cash in their reserve accounts with the central bank, they can expand their lending operations. They simply lend out this extra cash to the private sector and real economy. This is simply not true. The commercial bank has no actual control over reserve levels, and the link is indirect. (see for more http://www.standardandpoors.com/spf/upload/Ratings_US/Repeat_After_Me_8_14_13.pdf)

So, on to the more substantial point. If it’s reserves that matter and if there are excess reserves, what is the point of pushing even more into the system? The money is not being used as it is!

The point however is that it’s not the reserves nor the liquidity that expand lending. Rather, lending comes from individual banks changing their portfolio composition. In reality, when the Fed implements QE, what it does is buy long-term securities (henceforth simplified to be mortgages). Buying these mortgages helps to increase lending activity, not because the banks now have money in their checking accounts that they can lend out, but rather because banks strive to have a consistent level of long-term assets and liabilities relative to short term ones. When the Fed buys mortgages off of a bank. The bank will find itself with a more cash assets, and less mortgage assets. It’s portfolio’s composition will have changed. In order to address this the bank will strive to correct the portfolio and buy up mortgage contracts and assets off of the private sector. It will then credit the private sector with cash. Hence, when the Fed buys mortgages off of the banks, portfolio corrections means that it is really accumulating them off of the private sector. The private sector will then find itself with excess cash and the money should theoretically be invested or used.

Where the ‘flow’ of QE becomes important is in distorting the banking sector’s portfolio. As it stands, the banks are not inclined to correct their portfolios, and lending rates are not rising. But corrections back to normality DO nevertheless happen slowly, and the more balance sheets become liquid with cash exceeding mortgages, the more the banks will strive to correct their balance sheets, buying up mortgages off of the private sector.

Thus, QE works through the norms of the financial sector, and no matter how redundant inflating the monetary base through reserves may seem, it incentivises lending expansion regardless. Why are banks not so keen to rebalance their distorted portfolios? Is this situation permanent? The answer is a resounding no to the latter. Banks simply do not want to rebalance their portfolios because the returns on long-term assets have not been deemed valuable enough relative to those of highly liquid assets at the moment. In addition, the 0.25% interest rate payment that the Fed gives the sector for excess reserves provides an incentive to keep the asset compositions highly liquid. This means keeping the portfolios at above equilibrium levels of liquidity. That doesn’t mean that banks will completely disregard the portfolio norms however. Indeed, the more the Fed increases the liquidity of the balance sheets, the more the banks will strive to accumulate mortgages off of the private sector. Thus the private sector’s holdings of loanable funds increases, and interest rates fall.

 

*Disclaimer: I think I’m wrong

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