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I ‘ve recently received a few questions about the workings of QE so given the opportunity i thought it would be useful to analyze a few basic facts about quantitative easing in one post.

QE is basically an asset swap since the central bank operates in the secondary market. A long-term (high duration) asset is replaced with a deposit at the central bank (low duration). The balance sheet size of the seller does not actually change. The only wealth effect is any price appreciation of the corresponding asset which happens due to the purchases by the central bank. It works by:

  1. Strengthening the commitment by the central bank to low long-term rates, which should allow borrowers to lower their outstanding debt costs and any new loan interest rates.
  2. Removing duration from the market. Since certain investors are always long duration (such as pension funds) this increases the demand for remaining assets, lowering their yields.
  3. Removing safe assets from the market. Since the new assets (bank reserves at the central bank) cannot be rehypothicated, QE increases the demand for remaining safe assets (dependant on supply such as fiscal deficits).

In modern fiat monetary systems, with central banks employing a corridor system for setting interbank market interest rates (the interbank interest rate is floored by the deposit rate on bank reserves and cannot go over the marginal lending facility), which can be as narrow as they choose, the quantity of bank reserves can be set ‘exogenously’ in order to provide for bank liquidity needs as well as to steer long-term interest rates.

Banks do not need excess reserves in the central bank to lend to the real economy. They create a liability (deposit) whenever they provide a loan (asset) to the private sector. They could always use the same security to get cash in the repo market or by the central bank. Excess reserves are only used for interbank payments anyway and are never ‘lent’ to the private sector. M1-3 is (private) bank money, non bank private sector can only hold central bank (high powered) money in the form of currency. The latter is demand driven and the central bank will always cover the demand for currency by performing outright purchases of government securities (and priting currency leads to a debit of the bank reserve account of the bank that requested the additional ‘shipment’).

In order for the central bank to lower the opportunity cost of increased excess reserves it sterilizes QE through one of the following forms:

  1. By paying Interest on Excess Reserves. This is either equal to its target rate (Fed) or lower (ECB, through the deposit facility). So the Fed does sterilize its operations since banks are indifferent between lending in the Federal Funds market and keeping excess reserves (in reality, due to the fact that GSEs do not earn IOR the federal funds rate is lower than the Fed IOR and provides an arbitrage opportunity).
  2. By providing term deposits which is the main mechanism used by the ECB.
  3. By providing debt certificates, a mechanism that i would prefer for various reasons (see here).

As long as the sterilizing rate is lower than the central bank target rate, QE will drive the interbank rate closer to the deposit rate and the central bank will lose some control over the interbank rate (but can still steer the interbank rate with as much presisionl as it wants by increasing the deposit rate).

By lowering long-term rates a central bank also depresses the exchange rate, a fact that can be strengthened through carry trades. It might also ‘export inflation’ by inducing EMEs to lower their own rates in order to avoid appreciation of their own currencies, thus fuelling credit booms in their own countries. Lastly by making real rates negative it pushes investors to alternative investments such as gold and commodities which might end up in an push inflation cost on recovery. It is a well known fact that the price of gold appreciates when real interest rates are negative:

Low yields on safe assets induce market players to move to riskier assets, depressing their yields as well. As a result, spreads on corporate bonds are reduced and QE is considered bullish for stock exchanges. On a long-term path though, valuations will be based on macro developments than portfolio rebalancing.

As long as the central bank buys from bank clients (and not from banks themselves), the banks end up with an increased balance sheet which might hurt their planned leverage ratios.

In the Eurozone case, investors can select between assets to invest liquidity (in contrast with the US where the only safe asset is US Treasuries). In such a case, outright monetary operations targeted on specific issuers can lower their yields and provide for a buyer of last resort. Whether they will be effective in the long run will depend on:

  1. Macro developments and
  2. If the ECB remits profits to the issuing country and rolls over maturing paper. If it does not then it should be considered as an ‘investor of last resort’ instead of a creditor and it mainly moves the credit crisis into the future when its holdings mature.

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Kostas Kalevras

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