Former Fed Chairman Alan Greenspan was on The Kudlow Report on October 28 and Larry asked him about the effectiveness of the QE programs. Greenspan said that a large percentage of the money creation was being deposited at the Fed as Excess Reserves – not necessarily flowing back into the economy. He went on to say that once banks had more confidence in the economic environment, that money would begin flowing. That’s a different narrative from the one being presented by the controlling members of the FOMC. “We have found this to be an effective policy,” current Fed Chairman Ben Bernanke said about the QE bond purchases. How can Greenspan see it one way and Bernanke, Yellen & Company see it another?
Current State of Fed Policy
The Fed went “all in” during the financial crisis, pushing all of their chips right into the middle of the table. The federal funds rate was dropped to a range of 0% to .25% and an agency MBS buying program called Quantitative Easing was initiated. Since then, the Fed has dug deeper into their pockets and come up with even more chips, including: QE2, Operation Twist, QE3, QE4 and forward guidance. The Fed even started paying banks interest on any Excess Reserves left at the Fed, dubbed IOER. The net interest margin for banks was approximately 50 basis points before the financial crisis, it shot up to 100 basis points right after. Now, it’s averaging around 130 basis points. Banks are making more money, but there’s still a problem. With all the stimulus and low interest rates, it seems like the liquidity isn’t working its way into the economy – growth is slow and unemployment still high. There’s a blockage somewhere, a clog in the monetary plumbing, so to speak.
I know it’s an old monetary policy cliché, but the Fed is “pushing on a string” by buying Treasurys and mortgages in the open market in order to pump cash into the economy. The idea is to bring long-term interest rates down and get banks to make new loans. However, QE is not creating the results as hoped. Theoretically, on paper, all that stimulus is supposed to get economy going, stimulate business activity, and generating employment. So far, it’s not been as effective as predicted. That raises a question – has monetary policy, at this point in the economic cycle, become ineffective?
Perhaps the Fed believes they must act to do something and QE is the only tool left in the toolbox. The reason for the continue purchases could be due to the Fed’s dual mandate – to promote price stability and full employment at the same time. The Fed has the power to control prices because they control interest rates and the money supply. But for unemployment, they have an indirect influence at best. Whereas the Fed has been trying everything in their power to get credit flowing, other factors are working against them.
The reality is that while the Federal Reserve has dumped over $3.8 trillion in cash in the market through QE purchases, banks have sent over $2 trillion of it back at the Fed. Wait! Wasn’t that money supposed to be filtering its was through the economy and providing stimulus?
Suppose a bank owns $10 billion worth of U.S. Treasurys and they just sold them to the Fed in the QE program; the Fed gets the securities and the bank gets the cash. Does the bank then rush out and approve a bunch of marginal loans they weren’t sure they wanted to underwrite in the first place? No. Does the bank change their portfolio allocation and buy high-yield corporate bonds when their former choice was triple-A Treasurys. No. As it turns out, the bank is just taking much of that $10 billion and depositing it back at the Fed. It’s not part of the banks required reserves – they didn’t make new loans. It is deposited as Excess Reserves, which happens to earn more than other short-term triple-A investments with a .25%, IOER rate. The end result – the Fed buys Treasurys from banks and much of the cash ends up right back at the Fed.
Is there any proof of this? Well, the graph below illustrates it pretty well:
It’s pretty clear, as QE purchases increases the size of the Fed’s portfolio, some percentage of it gets deposited right back at the Fed as Excess Reserves. Whereas, the Fed has “printed” more than $3.8 trillion by easing quantitatively, over $2 trillion didn’t really go anywhere. Perhaps that’s the reason why the QE “money creation” hasn’t led to any inflation.
QE Effectiveness Ratio
Like any good economist, I want to make up an economic gauge, so I’m going to call it the “QE Effectiveness Ratio.” It’s defined as the percent of QE purchases that don’t end up as Excess Reserves. In other words, what percentage of QE money actually makes its way into the economy.
At the beginning of the first QE in 2008, over 60% of the QE cash was making its way into the economy. That ratio has recently dipped below 40%, meaning, as of the last data point, only 39.5% of QE purchase dollars are going into the economy. It makes sense, as the Fed keeps adding more and more, it’s bound to become less effective.
Continue Ramblings About Ineffective QE Purchases
The Fed is pursuing a potentially reckless monetary policy with continued QE purchases. Though I believe QE is effective when it’s used to correct a distorted market, like QE1 during the financial crisis, QE programs are clearly not effective when they’re used to distort healthy markets – like trying to force down long-term rates and get banks to lend in a somewhat healthy market.
Some commentators point out that inflation is subdued, and as long as there’s no inflation, we should keep the QE spigots running. The Fed shouldn’t keep doing something because there appears to be no negative effects at this particular moment. The QE program should be stopped because it’s not effective.