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Quantitative Easing and Money Magic

quantitative-easing-and-money-magic-body.jpgThis month, the Federal Reserve (Fed) has begun to “taper” the reinvestment of its $4.2 trillion balance sheet and wind down its extraordinary monetary policy of Quantitative Easing (QE). The Fed will do this by instituting caps on reinvestment of Treasury notes maturing and Mortgage Backed Securities (MBS) paying down principal. The program will reinvest Treasury proceeds over $6 billion and MBS proceeds over $4 billion to start. For example, if $20 billion of treasuries mature and $20 billion of MBS pay down, the Fed will reinvest $14 billion of Treasuries and $16 billion of MBS. This has the effect of decreasing total reinvestment by $10 billion a month. The plan is to increase these caps very gradually.

The Fed’s QE program is probably one of the most significant policies executed by either our government or an institution such as the Fed that is overseen by the government (somewhat at least) in decades. However, for much of the financial world, the policy is what Winston Churchill once called the Soviet Union: “A riddle wrapped in a mystery inside an enigma.” The two main questions most people have are how did the Fed create money and when they wind it down, how do they make the money go away?

Here is how the Fed created money through QE:

  • The Fed would ask the largest banks with MBS dealers a few days a week to offer, say, $3 billion Fannie, Freddie, and Gennie MBS.

  • The Fed bought the cheapest offerings until the $3 billion program requirement was filled.

  • In this process, when the Fed bought, say, $200 million MBS from a member bank, it took the MBS onto its balance sheet and credited the bank’s reserve account at the Fed for $200 million.

  • This creates excess reserves at the Fed.

Before 2008, excess reserves at the Fed totaled about $500 billion at any given time. Since the Fed was prohibited from paying interest on excess reserves, nobody kept spare cash at the Fed for too long. With the advent of QE, however, the Fed was permitted to pay interest on excess reserves. The interest rate the Fed paid on these excess reserves was (and still is) the upper bound on the Fed Funds policy rate.

Why pay interest on excess reserves? Because, when the Fed credits the bank that sold them the MBS, they have created new money. Presto! However, considering that excess bank reserves at the Fed got as high as $2.7 trillion by 2014, if the Fed did not pay a rate that would keep the banks from using that new money, inflation would have skyrocketed. In 2016, the Fed paid approximately $12 billion in interest to banks with excess reserves. In 2017, they will have paid probably $15 billion as the Fed has been raising the Fed Funds rate.

The next question is when the time comes to start unwinding QE and raising their Fed Fund policy rate, how can the Fed get rid of a lot of the money it created? Here are three different scenarios. The first two keep the money supply unchanged. The third is how the money supply QE created is disposed of.

  1. Assume a person with a $100,000 mortgage decides to prepay his mortgage because he just won the lottery. Let’s also assume that the person has his money with Bank A and his mortgage loan with Bank B. The $100,000 will come out of Bank A and go to Bank B. All else being equal, excess reserves at Bank A go down but excess reserves for Bank B go up by the same amount. There’s no net change to the money supply.

  2. Assume a person’s $100,000 mortgage is in a Fannie Mae MBS owned by the Fed. The person prepays the $100,000 mortgage and the $100,000, by way of Fannie Mae, goes to the Fed. As long as the Fed is reinvesting all principal pay downs from its $1.8 trillion MBS portfolio into new MBS, the $100,000 will end up as excess reserves of the bank that sold the Fed its new MBS.

  3. However, once the Fed stops reinvesting the principal pay downs as shown in scenario 2, the money goes to the Fed and the Fed makes the money disappear the same way they created it. If you imagine that these are paper transactions as opposed to electronic, then the picture in your mind should be the Fed taking the money and putting it into the shredder and presto, it’s gone!

The Fed has just started the third scenario, and the intent is to be very gradual. However, one thing to consider with this gradual pace is that the longer excess reserves stay elevated at the Fed, the longer the Fed pays banks on interest. As the Fed gradually raises rates, they pay more to the banks. The higher that number gets, it may become politically untenable to pay large banks billions not to lend money. This could throw a wrench into the gradual reduction process.

Member SIPC & FINRA. Advisory services offered through SWBC Investment Company, a Registered Investment Advisor.

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