Why QE Doesn’t Really work (4 min read)

The ECB is signalling that it may resume Quantitative Easing (QE) via bond purchases. And there is growing speculation that other central banks including the Fed could follow suit.

Meanwhile, a growing chorus of analysts including Macro Hive’s own Salomon Sabbag are pushing back, arguing that past QE programs haven’t really worked so far and that further ones could do irreparable harm.

QE was meant to boost lending

It’s a tough call to make – evaluating the effectiveness of QE is problematic as there is no clear theory of how it is supposed to work nor what exactly it is supposed to accomplish.  The general idea was that QE would reduce rates and support risk assets. That would somehow lead to demand for consumer and business loans. And the resulting economic activity would in turn boost inflation.

Indeed, when he was Chair of the Federal Reserve Ben Bernanke was sufficiently worried about excessive lending that he moved to start paying interest on excess reserves in part to give banks an incentive to keep reserves on deposit with the Fed.

He needn’t have worried. Throughout the post-war period, banks loan to deposit ratio stayed near 1, dropping mildly lower only during recessions. But once the Fed commenced QE, deposits soared and the loan to deposit ratio collapsed and remained around 0.75. Excess reserves climbed in line with deposits, indicating banks simply kept them with the Fed rather than using them to support lending (Chart 1).

A closer look at the Fed’s balance sheet shows that excess reserves have been declining recently. This reflects a shrinking portfolio of securities, a growing reliance on reverse repos, and rising currency outstanding (in line with a long term trend). It didn’t have much to do with lending activity.

But at least bank lending did eventually resume in the US around 2013, albeit at a slower pace than the pre-crisis era.

In the Eurozone, on the other hand, bank loans outstanding have flatlined since 2008. That is despite the ECB’s QE program, which started in 2015 and swelled its balance sheet by 3 trillion Euro to 4.6 trillion Euro (about 25% of Eurozone GDP), and two massive long term refinancing operations which were specifically structured to encourage bank lending.

The conclusion is inescapable. QE may have cut rates and pushed up asset prices, but very little of it wound up in the real economy in either the US or Eurozone.

Oddly enough, it’s even questionable whether the Fed paying interest on excess reserves inhibited lending. The ECB also pays interest on bank reserves through its overnight deposit facility – but these days the rate is -0.40%. Whether juicy or skimpy, interest on excess reserves doesn’t seem to have much to do with lending activity.

Clearly, something else is going on here. Let’s dig into this a bit further.

Blocked reserves

One of Bernanke’s concerns, when QE started, was that the money supply would explode. And it did, with M2 growth going from 5-6% annually before the crisis to over 10% during QE. What he forgot is that money affects the economy only to the extent that it circulates within it. Alas, even as the money supply rose, velocity (or rate of money turnover) collapsed from about 2 before the crisis to 1.4 following it.

The money supply jumped because deposits (a component of money supply) rose as follows: when the Fed was executing QE, banks purchased bonds from investors and paid for them by creating deposits. They sold the bonds to the Fed and received reserves. Investors then bought other bonds and securities, pushing up bond and stock prices.

Banks are often criticized for holding excess reserves instead of lending them out. But the reality is that banks can only lend reserves to each other via the Fed Funds market.  What they can do instead is transform excess reserves into required reserves through lending activity. They make loans to nonfinancial companies and consumers and create deposits that borrowers draw on. They have to hold required reserves against the deposit and do so with a transfer from excess reserves.

Clearly, the vast majority of reserves created through QE have remained excess reserves and thus outside the real economy (Chart 2).

Why haven’t QE programs entered the real economy?

Who knows. Banks may have viewed QE-related excess reserves as a form of ‘hot’ money that could be taken away as easily as it was created due to some policy or political shift and so they hesitated to leverage it. Some banks may have faced capital constraints. And loan demand may simply have been soft.

The bottom line is that analysts who are saying that further rounds of QE will do little to generate economic growth and inflation and could do more harm than good are surely correct. In any case it is difficult to see how more QE can do much to either cut interest rates or boost asset prices at this point.

The onus has to be on policymakers to figure out how to get unconventional monetary policy and QE into the real economy.

Maybe the notion of helicopter money isn’t so far-fetched.

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Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role. He can be reached here.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)

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