Sunday, June 5, 2011

So what is QE?

Many are under the impression that with the end of the Fed's Treasury purchases, the Fed will not be pumping more money into the economy and that constitutes a monetary "tightening". I believe that this way of thinking is incorrect. As interest rates were lowered, monetary conditions could adequately be described as "loosening". As the Fed continued to keep the interest rate at a very low level, the policy could aptly be described as a continued easy monetary policy.

However, it is at this point that the Fed embarked on their quantitative easing policy. The traditional rate cutting had already taken its course, and then the Fed started pumping the additional liquidity. Hence the cessation of the Treasury purchases by the Fed, would not be described as the end of easy money. Interest rates are at historic lows, and monetary tightening will not begin until the Fed starts unloading its balance sheet.

Another misconception is as to the way QE helps the economy. Fed buys treasuries, the extra money finds its way into the economy. Yes? NO. The Fed purchases Treasuries from a dealer, whose ability to then make other purchases allowing the additional money to finds its way into the economy has practically no bearing on the extra "money" from the Fed. If the dealer wished to purchase additional oil futures, or stock futures, he could do so with very little margin. The transaction from the Fed has no effect.

What it does do is it increases the monetary base, and through the money creation effect, this has the ability to add new money through additional bank lending. With the current reserve requirement 10%, $600 billion has the potential to add $6 trillion in new money. However, either because the banks have been so pre-occupied in repairing their own balance sheets, or the public has not been willing to take on bank loans due to the vulnerability of the economy, the banks have not been lending the extra potential money into the economy.

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