The Smoke and Mirrors behind Quantitative Easing

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Another QE bazooka from the Central Banks, with the European Central Bank (ECB) announcing last month that another €1.1 trillion of money will be pumped into the Eurozone economy.

Over the past number of years I have heard time and time again that the massive rounds of quantitative easing (QE) taken by many of the Central Banks around the world is going to result in massive inflation, if not hyperinflation. Having spent a number of years in the Lion’s Den so to speak, working as a bond dealer with the Central Bank of Ireland, I saw firsthand the ‘money creating’ and bond buying activity that happens with QE. It gave me a valuable perspective, one that highlighted the problems with a simplified ‘creating money causes inflation’ line of reasoning.

When a Central Bank creates money to fund purchases of its QE portfolio, the new money created does not increase the amount of money in the economy (like every good economist Ill qualify with “bar second order effects”; more on this below). Instead, the new money increases the size of the Central Bank’s balance sheet. When a Central Bank creates money (issuing reserves using polite central banking language) in order to pay market makers/brokers for the purchase of government bonds, it removes the same amount of assets (bonds) from the balance sheets of those market makers/brokers. The result is that no new net financial assets enter the economy. This process is not a one way flow of money into the economy, as is often mentioned in the media.

So it’s better to think of QE as an asset swap. Better again think of it as a liquidity swap. The important concept is that QE does not increase the total money supply in the economy; rather it increases the size of the Central Bank’s balance sheet. Liquidity refers to the ease with which money can be used. Cash in your bank account can be used at a moment’s notice. However, cash tied up in the value of your home, cannot be easily used for these purposes. The cash in your bank account is highly liquid, but the cash tied up in your home is not.

How does the QE Process, Banks & Money Supply Interact?

When a Central Bank engages in QE, it takes low liquidity money (government bonds) out of circulation and exchanges them for cash reserves, which can be lent or used to purchase assets. The net result is that the high liquidity component of the money supply gets bigger in relation to the low liquidity portion, but the total money supply does not grow. The way the total money supply in the economy grows is through bank lending – a function of the fractional reserve banking system. So perhaps the best way to look at the net effect of QE from a ‘money’ perspective is that it changes the shape of the liquidity profile of the aggregate money supply (the total amount of money in circulation stays the same). Quantitative easing does not change the quantity of the total broad money stock; it just increases the liquidity of the total broad money stock.

QE: Debt Monetisation?
As an ex Central Banker my view is that QE can have implications for inflation, but not directly from the QE itself. Central Banks operate a ‘sterilisation’ policy which refers to how the money which is generated from a QE portfolio is dealt with when it is paid back to the Central Bank. The coupons and redemption proceeds from QE portfolios are effectively burnt (reserves cancelled) when received by the Central Bank which means that government debt is not monetised (proceeds are sometimes reinvested to keep the QE portfolio at a target size). Instead the likely cause of inflation due to QE could come as a result of a dramatically increased total money supply resulting from the fractional reserve banking system.

Given the low levels of bank lending over the past few years, with no uptick in sight, and the continual grind lower of inflation prints, the short to medium term should see relative stable inflation expectations. What all this means for our clients, many of whom manage interest rate and inflation rate risk, is that they should consider how responsive their hedging portfolios are to a changing wider economic environment. A change in tone from the Central Banking community around future interest rate policy, in the event of rising inflation prints or rising inflation expectations, should warrant a timely review and realignment of hedging strategies. First mover advantage could be the key to being successful in a world where the power of fractional reserve banking is revealed once more.

Crevan Begley, Manager, Client Strategy & Research, EMEA

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