QE2 End Games - Mr. Bernanke's Dilemma

April 19th, 2011
in Op Ed

bernanke-steve by Rick Davis

QE2 is supposed to wrap up sometime in June. The question is: will it actually end in June? Or, to rephrase that question in a more political context: is it in anybody's interest to have it end then?

Follow up:

It may be useful to reflect back to a time a little over two years ago when most economists were concerned that the Federal Reserve had expended all of its monetary policy weaponry against the "Great Recession" to no avail, caught in a version of what Keynes characterized as a "liquidity trap." Interest rates were effectively zero, and yet credit was not growing and the economy was not recovering. It was becoming clear that two factors were at work:

-- Banks were loathe to loan new monies to non-credit-worthy borrowers;

-- And other borrowers who were still credit-worthy simply wanted no more debt (explaining in large part why they had remained credit-worthy in the first place).

In fact, even existing credit was being extinguished as credit-worthy borrowers deleveraged and non-credit-worthy borrowers defaulted. In short, we were experiencing a very real credit collapse. And the Federal Reserve was then presumed to have no conventional monetary tools left that could reverse that situation.

Following the Bank of Japan

That's when Mr. Bernanke entered the realm of the "unconventional," borrowing a tool previously used by the Bank of Japan to deal with its own great recession -- now nearly two decades old. That tool was "Quantitative Easing" (QE) which amounts to the central bank injecting liquidity directly into the banking system by swapping fabricated-from-thin-air excess bank reserves for outstanding governmental or commercial debt instruments. From a balance sheet standpoint this process essentially expands the Federal Reserve's assets by the amount of the purchased debt instruments and offsets those assets with liabilities in the form of freshly minted bank reserves electronically fabricated and credited to the money-center banks' accounts.

The Federal Reserve's initial experiment in QE (starting in November 2008 and now known as QE-1) was also used to move vast amounts of lower quality mortgage-backed securities from the balance sheets of commercial banks to the balance sheet of the Federal Reserve. By June 2010 the Federal Reserve had increased its total portfolio of securities by $1.58 trillion, of which $1.13 trillion was mortgage backed securities. In the first quarter of 2010 it was thought that a full recovery was underway, and the Federal Reserve began to contemplating "unwinding" its positions.

Enter QE2

But by August 2010 the recovery had begun to look less robust, and another round of QE (now known as QE2) was announced. The initial QE-2 purchases were designed to simply offset the shrinking value of the mortgage-backed securities with fresh U.S. Treasury issues (because the value of the Fed's mortgage-backed securities portfolio has shrunk by nearly 18% since May 2010 as a consequence of normal principal payments, refinancing retirements and some foreclosure activity). But by December 2010 the purchases had increased substantially beyond what was necessary keep the total portfolio balance level, bringing the total of all Federal Reserve QE purchases (QE1 and QE2) through early April 2011 to $2.02 trillion, with an additional $0.20 trillion planned before the end of June 2011.

What Has QE Produced?

It's reasonable to ask what over $2 trillion of additions to the Federal Reserve's balance sheet has accomplished:

-- Since QE1 commenced in November 2008 the
Federal Reserve's Employment-Population Ratio has dropped from 61.4% to 58.5% (i.e., nearly 3% less of the population is employed). Meanwhile the official headline unemployment rate grew from 6.8% to 8.8%;

-- Household income has stagnated in the face of price inflation in household staple commodities: corn prices are up 103%, oil prices rose 122% and cotton spot prices quadrupled;

-- The longer end of the Treasury's yield curve rose over 200 basis points (80%) from a bottom reached in December 2008.

-- On the home front, residential real estate prices have dropped an additional 9%, housing starts have dropped an additional 10%, and foreclosure filings increased 23%;

But on the brighter side of things:

-- The price of Gold is up 75%, the S&P 500 is up 48% and earnings per share for the S&P 500 are up 39%.

As with many experiments, QE has generated some unexpected results. As an example, by conventional economic reasoning the injection of vast amounts of new liquidity should not have driven long bond rates (or mortgage rates) up. As another example, banks were expected to put more of that liquidity to use in ways that stimulated real commerce.

Looking at the big picture, we might wonder: what are the observable macro-economic results of the Federal Reserve's great QE experiment since November 2008? At least two observations come to mind:

-- There has been a bubble in financial assets and commodity prices, even as real estate prices have continued to deflate. This has been largely due to the mechanism used for the injection of the liquidity -- increasing the excess bank reserves of money-center banks. Those banks, in turn, deployed the excess reserves in the ways that they felt would generate (for them) the greatest profits -- speculating on financial assets and commodities (and certainly not real estate or mortgages).

-- Despite the financial bubble, "Main Street" Americans have fewer jobs per capita, lower household worth and less disposable income. This can be considered collateral damage from the use of self-serving banks as the liquidity recipients, since essentially none of the liquidity has been put into productive capital that can grow U.S. commerce, jobs or median real household income.

The experience of "Main Street" Americans during QE has not been materially different from the experiences of their Japanese counterparts over the past ten years -- a history that the Federal Reserve surely understood before injecting $2 trillion of liquidity onto the balance sheets of select U.S. banks. So, why has QE become the stimulus tool of choice?

The Bank of Japan's answer is simple: presumably things would have been much worse without QE -- i.e., the injected liquidity neutralized (to some extent) an ongoing deflationary credit contraction. And, not so incidentally, they had no other tools left in their monetary toolkit.

By the way, after nearly ten years of QE, the Bank of Japan has not been able to execute an exit strategy. But they have learned two critical things:

-- Nobody really cares about central bank balance sheet bloat; and,

-- They were able to monetize and even further domesticate their government's sovereign debt, keeping the unprecedented debt/GDP ratio affordable and deferring the need to address the structural fiscal deficit issues -- and all without trashing their currency's exchange rate.

As a stimulant for Japan's economy, QE was arguably a complete failure. But by happy accident, the experiment managed to kick an a 200% debt/GDP ratio (twice as bad as in the U.S.) down the road for a decade.

What About China?

That happy accident is not trivial, nor is it likely to have been overlooked by Mr. Bernanke. As little as a year ago economists were concerned about the possibility of the U.S. Treasury's largest creditor (China) suddenly dumping their holdings to repatriate their stash of foreign exchange surpluses for domestic use. That is literally no longer a concern -- simply because the Treasury's largest creditor is now the Federal Reserve (compare the Fed's current $1.35 trillion holdings to China's measly $1.16 trillion). The Fed has roughly doubled its holdings over the past year, and at their current pace of year-over-year Treasury acquisitions Mr. Bernanke could (and almost certainly would) sop up the entire Chinese position in less than two years.

Perhaps more importantly, for the past five months the Federal Reserve has bought and monetized the entire net new U.S. Treasury debt. If we engage in some (presumably) hypothetical arithmetic in something akin to economic "magical realism," the Federal Reserve has put into place and tested a means of monetizing over $100 billion in new U.S. Treasury debt per month -- potentially (and magically) financing a $1.4 trillion annual fiscal deficit for at least a decade (if Japan's experience and 200% debt/GDP ratio are any guide). And above all, on the short term this financing would be painless for the electorate and a bonanza for the financial elite.

Bernanke's Options

Consider for a moment that there are only three broad options for Mr. Bernanke at the end of June:

-- Unwind the cumulative effects of QE1 and QE2, sending us back to late 2008 in more ways than we would care to remember;

-- Restrain new purchases but hold the current inflated balance sheet levels intact, eventually causing budget-busting debt servicing costs as the Treasury falls into the unwelcoming arms of the "bond vigilantes";

-- Continue QE either directly or indirectly, while selling "Main Street" on how great the equity markets have done.

If Mr. Bernanke has learned his lessons well, there is no dilemma. It's an almost magical "no-brainer" that only our children may regret.

Related Articles

China Stops Buying U.S. Debt?  Could be a Good Thing by Michael Pettis

The Week Ahead:  Hype About End of QE2 is Overblown by Jeff Miller

The Great Debate©:  Inflation or Deflation? by Robert Huebscher

Will There be Life after QE2? by Steven Hansen


Rick Davis is founder and CEO of the Consumer Metric Institute. The Consumer Metrics Institute (CMI) provides timely and quality information about the consumer economy in the United States. Background information on CMI is available at http://www.consumerindexes.com/Overview.pdf.


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  1. Derryl Hermanutz Email says :

    Rick has written a very crisp synopsis of the Fed's QE programs and Bernanke's options at the end of June. But he failed to mention the mechanism by which QE2 money actually gets into Main St's economy.

    We all know that the Fed is cycling its purchases of newly issued Treasury debt though the PD banks, who buy the debt from Treasury then sell it on to the Fed as little as 2 weeks later. The PDs buy Treasuries by crediting Treasury's accounts at their banks. These credits are the "money" Treasury then spends into the economy as "deficit spending". The Fed then buys those Treasuries from the PDs by crediting their reserve accounts, but the banks had already "spent" that money buying the new Treasuries that they subsequently sold to the Fed.

    So ultimately it is the Fed who creates the new money by creating PD bank reserves which cover the credits the PDs advanced to Treasury. The government is the only party who ends up with the new money to spend. The PDs simply collect fees for being middlemen in this process. The government spends the money into the economy where it becomes "incomes" to all the government workers and suppliers and program spending recipients.

    This is no different, from a cash flow perspective, than investors or consumers borrowing and spending money into the economy. The deficit spending that QE finances supports Main St incomes and the real economy that is activated by spending or investing money. Rick mentioned the nuclear option of ending QE and ending deficit spending and returning to the late 2008 economic collapse scenario. That's what would happen if the economy suddenly lost $100 billion per month of incomes.

  2. Rick Davis says :


    Thank you for your comments.

    You are correct in your observations of how the currently minted Quantitative Easing (QE) monies are actually reaching the economy, through the Federal Government's deficit spending as financed by the new Treasury issues.

    But the current situation is a confusing collision of QE (which is the implementation of a monetary policy to increase liquidity by expanding the money supply through the creation of new credit) and Fiscal Stimulus (which is the creation of increased aggregate economic demand through Keynesian inspired deficit spending). It happens that for the past two quarters the amounts of QE have more-or-less matched the amounts of deficit spending, so that from a cash flows standpoint the QE monies might appear to be ending up in the economy via Federal Government expenditures.

    QE could exist absent any fiscal stimulus. In that circumstance the QE purchases of Treasuries would simply replace maturing issues previously held by other buyers (e.g., China). But the monetary policy impact of the QE purchases would be to increase money supply credit in the form of the increased Primary Dealer (PD) reserves held in the PD accounts at the Federal Reserve -- i.e., the increased liabilities that offset the newly purchased Treasury assets on the Fed's balance sheet. Those excess PD reserves are then presumably lent to other banks in need of reserves for end-consumer lending purposes, and the total credit available to the economy is supposedly increased.

    For better or worse, this time around nearly all of the newly minted QE liquidity has ended up sitting in cash in the PD accounts, and the whole exercise to increase net "Main Street" credit has been a bust. In effect the "velocity" of the injected new liquidity has been zero.

    But by happy accident of the numbers, we have managed to domesticate more of the Treasury debt by making the Federal Reserve the largest holder of such issues. And, as you point out, at least the new Treasury issues have ended up in the economy via the stimulating fiscal effects of the deficits -- even if fiscal stimulus was not the original intent of QE.

    Thanks again for the comments,

    Rick Davis
    Consumer Metrics Institute

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