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Follow Up: QE is not Inflationary, Thoughts on Risk Asset Instability

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February 02, 2011 – Comments (13)

This is a Follow up to my last post QE is not Inflationary, Thoughts on Risk Asset Instability - http://marketthoughtsandanalysis.blogspot.com/2011/01/qe-is-not-inflationary-thoughts-on-risk.html / http://caps.fool.com/Blogs/qe-is-not-inflationary/531743. I received a lot of good comments that allowed me to make clarifications to my argument. I would like to consolidate those clarifications and add a bit more to my observations. This will be a more complete post than my last one, and I think will be a useful exercise.

*** The Federal Reserve buying and selling Treasuries is a Monetary Operation, not a Financing Operation

I have gone through this in detail here (The Matter of Deficits, Sovereign Default, and Modern Monetary Theory) and here (The US Treasury and the Federal Reserve: Redundant Institutions). Both of these pieces were influenced heavily by The Pragmatic Capitalist who I believe understands the current reality of Fed / Treasury operations better than anybody.

Here is the highly simplified and shortened version of the two posts above:

Treasuries do not fund anything. Once upon a time (prior to 1971) they did. But they are no longer a fiscal (financing) tool. They are a monetary tool. Treasury auctions are the mechanism by which the Fed maintains its overnight rate. The Fed purchases or sells Treasuries in order to add or drain excess reserves. That's it.

Open Market Operations (see here) are how this process is carried out. Sometimes this involves new Treasury issuance to cover the amount of reserves the Fed needs add, and sometimes this involves only existing Treasuries which could come from banks, Primary Dealers, or an authorized Government Securities Trading Desk. The main point being that Treasury auctions and purchase or sale of treasuries by the Fed is a completely co-ordinated activity (by design) simply done to maintain control of their target rate, and as such will never be under-subscribed (again by design).

Note: This is different than 'Government Spending'. As I said above, Treasury issuance is entirely a monetary operation, it is not a financing operation (not since 1971). When the US Government wants to spend, it simply spends. More specifically, the Treasury credits bank accounts directly. This is exogenous to the banking system and has been termed 'vertical money creation', as opposed to 'horizontal money creation' which happens completely in the banking system. For more on this, see here. This also illustrates why the US Government is not revenue constrained. It must first credit accounts so that money can disseminate through the economy, one use of which is to pay taxes. Neither Taxes nor Treasury Issuance 'funds' Government activities.

... [ However government spending *MUST* be in some proportion to private sector productive capacity otherwise inflation will ensue. There is no 'free lunch' here. But the point of this section is to discuss the specifics of monetary operations, which is highly relevant to this post ]

*** Excess Reserves and Bank Lending

Under neo-classical economic theory, a large amount of excess bank reserves will lead to an increase in bank lending via the Money Multiplier Model. The very abbreviated version goes like: In a Fractional Reserve Banking System the total amount of loans that commercial banks are allowed to extend (the commercial bank money that they can legally create) is a multiple of reserves. Which means the higher amount of reserves, the more loans / credit money can be created.

However there are a number of issues with the Money Multiplier Model in terms of being the driver of forcing monetary policy. It basically is a 'supply side' theory in which the bottleneck is the banking system. By increasing the reserves in the banking system, more loans will be made because there is a higher capacity to create loans. This does not hold up with empirical observations (see here).

Operationally, banks are never really reserve constrained. Reserves only need to be met against a 14 day average, which means if you are a bank you can make a loan absent the required reserves at any point. Reserves can be acquired either through interbank lending or the discount window. Moreover, reserves need to be carried against demand deposits (checking accounts). Sweeps have been routinely implemented to move demand deposits into a special purpose savings account (a savings account is not a demand deposit) obviating the need for higher reserves.

In a fantastic paper by Austrian Economist Vijay Boyapati (see here) observation has shown that bank reserve creation by the Fed actually lags banking sector lending

Given that commercial banks are effectively operating without a reserve requirement and that loan issuance is not constrained by reserves, it would be sensible to reconsider the temporal causality posited by the money multiplier theory of lending. If the causality were correct, one would expect changes in reserves to precede changes in the issuance of credit, ceteris paribus. Citing an empirical study on business cycle statistics conducted by the Federal Reserve, Steve Keen explains that the opposite is true:

…rather than [reserves] being created first and credit money following with a lag, the sequence was reversed: credit money was created first, and [reserves were] then created about a year later.

From an Austrian perspective, an empirical argument based on a temporal correlation is not definitive proof of an underlying causality — although it may be illustrative and suggestive of that causality. An explanation for the counterintuitive temporal sequence is provided in a Federal Reserve study of the institutional structure of the US banking system since 1990, conducted by Carpenter and Demiralp. They demonstrate that “reservable liabilities fund only a small fraction of bank lending and the evidence suggests that they are not the marginal source of funding, either.” Their point is that when a bank makes a loan, the matching liability used to fund the loan does not need to be reserves created by the Fed.


These are particularly relevant points, because the size of the monetary base exploded by over $1 trillion in 2008 (see http://research.stlouisfed.org/fred2/series/BASE) and we have not seen any commensurate explosion in bank lending since 2008 (see http://research.stlouisfed.org/fred2/series/TOTBKCR?cid=49). Also broader monetary measures like M2 and M3 (see http://www.nowandfutures.com/key_stats.html) show the still disinflationary / deflationary monetary trends.

The problem is not a 'supply side' (bank reserves) issue, rather it is a 'demand side' (unwillingness to borrow) issue.

For inflation, which is a persistent increase in money supply and credit resulting in a persistent increase in prices, to take hold and become a problem the US private sector needs to borrow. And since the private sector remains in a balance sheet recession, this significantly reduces the inflationary potential of the monetary base in the current environment.

*** Why Quantitative Easing is not Inflationary

Quantitative Easing is an asset swap.

At the end of the day, it is nothing more fancy than that. The Fed takes excess reserves and purchases Treasuries. This is exactly the same type of operation that the Fed undertakes when trying to maintain the Fed Funds Rate as described above.

Under normal OMO, the Fed buys the short end of the yield curve. Under the Quantitative Easing 'Two' program, the Fed is mainly targeting 4 to 10 year securities (see http://www.newyorkfed.org/markets/lttreas_faq.html).

The main goal of Quantitative Easing, as stated by Chairman Bernanke in August 2010 during his speech at Jackson Hole was to lower long term interest rates, which will stimulate borrowing and then eventually stimulate the economy. (see http://www.federalreserve.gov/newsevents/speech/bernanke20100827a.htm)

A first option for providing additional monetary accommodation, if necessary, is to expand the Federal Reserve's holdings of longer-term securities. As I noted earlier, the evidence suggests that the Fed's earlier program of purchases was effective in bringing down term premiums and lowering the costs of borrowing in a number of private credit markets. I regard the program (which was significantly expanded in March 2009) as having made an important contribution to the economic stabilization and recovery that began in the spring of 2009. Likewise, the FOMC's recent decision to stabilize the Federal Reserve's securities holdings should promote financial conditions supportive of recovery.

The problem is QE-I and QE-II happened in completely different environments. The crisis of 2008 was primarily a deleveraging crisis. QE-I added liquidity to the banking system when it needed it after the Lehman collapse. I have discussed that previously here: Moving Some Macroeconomic Deck Chairs: The Dollar, Dollar Swaps, Bonds and LIBOR.

However, as discussed above, the current environment is different. Excess reserves and the monetary base are at unprecedented levels. Banks are not reserve constrained. There is no liquidity crisis now. So if bank lending has not increased substantially with $1 trillion in reserves, why would an extra $600 billion make much difference? ($600 billion is the amount of Treasury securities to be purchased - http://www.federalreserve.gov/newsevents/press/monetary/20101103a.htm)

This makes the stated intentions of Quantitative Easing suspect. But let's put that idea on hold for a minute and focus on the mechanics of Quantitative Easing to show why it is not inflationary.

The Fed wishes add reserves to the banking system (recall at the beginning of the post, the Fed purchasing Treasuries adds reserves to the banking system). It also wishes to change the structure of bank balance sheets so that banks are holding less Treasuries themselves and will take on more reserves (which presumably will make then more inclined to lend, ... which as was discussed above is not the problem). So in this case, the Fed does not want to buy Treasuries from the Treasury, it wants to buy the Treasuries on bank balance sheets.

In this case especially (as is often the case in OMO) the Treasuries already exist. They are already a part of the financial system. When the Fed buys these Treasuries and transfers them to its balance sheet, it gives the financial institutions an equal amount of reserves. At the end of the transaction, there are no new net financial assets in the banking system. The structure of the assets are different, but the amount of assets are the same. It quite literally is an asset swap. For a more detailed description of this process, see here

There is no increase in money supply. The mechanics are not inflationary.

QE is actually deflationary since it takes an interest bearing asset away from the financial sector and swaps it for reserves (which currently pay only 25 bp).

The only way for Quantitative Easting to be inflationary is if all of these new bank reserves spurred an increase in lending, and that is not happening.



ENLARGE

The current environment is disinflationary and borrowers are not willing to take on more debt. Increasing bank reserves, based on the argument I present above, doesn't seem like it will make much difference (at least not an inflationary one), and so far that looks to be the case.

*** Who exactly are the buyers and sellers in QE-II?

Yet, since the end of August after Chairman Bernanke gave his speech at Jackson Hole, almost every risk asset class has gotten a bid, and big time.

Is there some causal (yet hidden) inflationary activity occurring here?

I argue the answer is 'mostly' no .... and a lot more dangerous over the long term than an outright 'yes'.

First, addressing the Fed's stated reason for Quantitative Easing, which was to lower long term interest rates (by buying that part of the curve), we see that in fact the opposite has happened:



ENLARGE

Longer term yields have increased since QE-II began.

So, we have an increase in long term yields (opposite of the stated intention) and we have a decrease in lending (opposite of the stated intention).

Bank reserves have increased, but bank reserves cannot be used for speculation. Bank reserves are on account at the Fed and can be used to purchase Treasuries, MBS's, or loaned interbank to those that need it for reserve requirements. This is true for all commercial banks, investment banks, primary bond dealers, or other government securities dealers who have an established trading relationship with the Fed.

..... Hmmmmm. We seem to have found a dead end in our analysis.

We have a terrific rally in all kinds of risk assets since QE was hinted at by Chairman Bernanke at the end of August, which continued with gusto when QE was officially announced at the beginning of November.

Since I have shown above the QE is not inflationary (no increase in the overall money supply), then there are three reasons for this rally.

1) "Animal Spirits" only (used intentionally pejoratively)

2) The majority of all investors mistakenly believe QE is inflationary and are simply front-running the Fed based on improper understanding

3) Something about the structure of QE is changing the liquidity in the system

I suppose we could just assume idea 1 (Keynes famous "animal spirits" idea, which basically says that anything that doesn't fit into his economic theories is just irrational behavior). While potentially the whole story, it's not a very compelling story and I would be a lazy analyst if I just left it there.

I also suppose idea 2 might work as well. But there are very smart people in the market, and I think if I could figure out that QE was not inflationary (at least highly unlikely at any rate) others much smarter than me and in control of more money would also. The flip side is that maybe they are playing off the misconceptions of others and 'front-running the front-runners'. And while I think that is part of it, that is still analytically unsatisfying and I don't think comes close to describing the sheer size of the rally the last 5 months.

I will spend the rest of this section focusing on idea 3.

Fair warning: this train of thought is my own pet theory. It may or may not hold up to scrutiny, but I believe the logic to be sound.

First lets return to the Treasury purchases. The Fed is purchasing these Treasuries through Open Market Operations. Ideally the Fed wants only banks to participate in these auctions, but they are Open Market. Which means that any Government Securities Trading Desk can bid at the auction. But lets operate under the theory that most of the Treasury sales are coming from banks. If that were the case we should see a decrease in bank holding of Government Securities starting in November (QE-II POMO is ~$75 billion per month from the FOMC statement).

This does not jive with the data:



ENLARGE

There is a drop in November, but is not $75 billion (only about $20 billion)

Now I would like to return to the observation about bond dealers. Primary dealers are often very connected with investment banks (here is the Primary Dealer list from the NY Fed: here). These institutions obviously have ties to the large bond holders (funds and institutions) in the world.

So while a Primary Dealer or any Government Securities trading desk can trade with the Fed, they get paid in reserves which stays on account with the Fed, and can't be used for speculation. But there would be nothing stopping a Primary Dealer buying Treasuries from the bond community (say an Investment Bank who might be a seller based on QE) and in turn selling to the Fed. This could be accomplished through the repo market via a term repo (see http://wfhummel.cnchost.com/repos.html).

But just thinking like bond holder for a second, if a large institution (such as the Fed) with a huge amount of reserves was able to soak up a large amount of Treasury selling, then why not sell some now and purchase later? Think of it like this, if all the long term Treasury holders go to sell at the same time, prices will plummet and yields will skyrocket. But if a party steps in and says 'I am buying half a trillion or so of long term Treasuries', then why not sell part of your position and book some profits (or speculate if a large buyer is putting in a partial floor)? If a number of people think think this, and it is larger than what the Fed is purchasing, then prices will drop based on the selling pressure. But it would be less than it would otherwise be since the Fed has announced that it is a large buyer. And since you are a bond investor, and you are smart, and you understand that QE is deflationary (from the observation above), then likely you will get a chance to repurchase your Treasuries at a better price sometime in the future (from the current selling activity and the fact that it will likely trend for some time) and prices will likely recover.

This idea jives with both the observation on the yield curve (Treasury prices are falling, not rising) and the fact the most of the Treasury selling is not coming from banks.

*** A Speculative Increase in the Price of Risk Assets and the Fed's Third Mandate

So let's assume for moment that my bond market theory is correct. Is it inflationary?

No.

Again, QE does not change the amount of net financial assets in the system, it only changes the composition. But what I have described above is a way for more liquidity to be available to chase risk assets.

It is something like a currency carry trade. An investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used. In a carry trade, no currency is created. Traders hold the positions on their own balance sheets and then eventually unwind them. (The primary dealers would be the carry traders in my above example).

So even though this scenario is not inflationary, it would explain how additional liquidity could be made available for speculation.

But let's say that my idea is bunk. That there are no bond sales freeing up liquidity for speculation purposes.

It would then mean that (since I have shown there is no inflationary impact from QE) that either 'Animal Spirits' (again, I think this is ridiculous as a going-in assumption) are out in full force or everybody is front-running the Fed in a mistaken idea about the nature of QE.

My main point here is that in all three of these cases, there has been a sharp increase in risk asset prices across the board (many different asset classes) with no commensurate increase in the money supply

Both the nature (severity) of this rally and its timing scream 'speculation' to me.

Now please, don't misunderstand what I am saying. Excess liquidity and/or the urge to speculate does not guarantee a rally. There has to be some basis for speculation, and with stocks in particular, all of dominoes did in fact line up:

a) There had to be actual GDP growth occurring (which there has been)
b) Earnings has to be growing (and they have been)
c) Corporate balance sheets had to be improving (and they did)

There are some legitimate reasons for investors to be bullish right now, and I am saying that part of the rally is for that reason. But how it has manifested, and how the market reacted in all risk assets, not just stocks, to the QE hints and then the official announcement has a speculative stench all over it.

With respect to the Fed, having failed at their primary reason for QE-II (lowering of interest rates and the stimulation of more lending) could be for two reasons: i) They did not understand that this would happen (unlikely) or ii) This was not in fact their primary reason for QE-II.

In retrospect, the real reason for QE-II was so that the Fed could add a Third Mandate:

To keep risk asset prices higher than they would otherwise be

So while I think that the next few years will likely see a continuation of this cyclical bull stock market (P/Es are in another expansion cycle right now, and the market is getting a goose from excess liquidity [potentially] and certainly excess speculation), this gets at the heart of why I think this is unstable over the long term.

I talked about many of these thoughts here: Macro Thoughts and Observations. Is the Bear Market Dead? Is this the Start of a new Secular Bull Market?

Over the long term, as economic fundamentals cannot support the revenue streams to generate the earnings that artificially inflated stock prices expect to keep growing, then we have crashes. The 2000-2002 crash was based on the unsustainable dot-com valuations. The 2007-2009 crash was based on unsustainable consumer spending due to the housing bubble bursting as well as deleveraging of financial assets tied to the housing bubble. The next bubble will likely form (and pop) due to excess liquidity or excess speculation (or both) in risk assets that get completely divorced from sustainable fundamental economic drivers.

This makes this wave a bubble in motion, but I don't think it is at it's popping point yet.

Here are John Mauldin's thoughts on the FED's Third Mandate (which I completely agree with): (see: http://www.johnmauldin.com/frontlinethoughts/thinking-the-unthinkable)

The Fed has two mandates: keeping prices stable and creating an economic climate for low unemployment. I am sure I was not the only one to listen to Steve Liesman's interview of Ben Bernanke this week and shake my head at the spin he was giving us. First, let's set the stage.

In a paper with Alan Blinder early last decade, Bernanke made the case for the Fed to target a specific inflation number, and the number that came to be accepted as his target was 2%. In his famous helicopter speech in late 2002, he assured us that inflation could not happen "here," even if the short-term rate was zero, because the Fed would move out the yield curve by buying large amounts of medium-term bonds. This would have the effect of lowering yields all along the upper edge of the curve. This became known as quantitative easing. In Jackson Hole last summer, he made very clear his intention to launch a second round of liquidity-injecting quantitative easing (QE2). In that speech, in later speeches in the fall, and in op-ed pieces he said that such a program would lower rates.

Then a funny thing happened on the way to QE2: long-term rates began to rise all over the developed world. As Yogi Berra noted, "In theory, there is no difference between theory and practice. In practice, there is." It's got to be driving Fed types nuts to see the theory of QE, so lovingly advanced and believed in by so many economists, be relegated to the trash heap, along with so many other economic theories (like that of efficient markets). The market has a way of doing that.

So, Liesman asked Bernanke about one minute into the clip (link below) about the little snafu that, following QE2, both interest rates and commodity prices have risen. How can that be a success? Ben's answer (paraphrased):

"We have seen the stock market go up and the small-cap stock indexes go up even more."

Really? Is it the third mandate of the Fed now to foster a rising stock market? I wonder what the Fed's target for the S&P is for the end of the year? That would be an interesting bit of information. Are we going to target other asset classes?

Understand, I am not against a rising stock market. But that is not the purview of the Fed. And certainly not a reason to add $600 billion to the balance sheet of the Fed when we clearly do not understand the consequences. If it looks like they're making up the rules as they go along, it's because they are.

Here is the clip: http://www.cnbc.com/id/15840232/?video=1742165849&play=1


The Fed wants a risk asset rally, and it got it. And it wants the cyclical bull market to continue, and I think it will do that too. It's primary goal is to create a 'wealth effect' from a rising stock market. While that might have some short term impact, it has a very dubious long term impact: http://pragcap.com/robert-shiller-debunks-stock-market-wealth-effect.

But keeping asset prices 'higher than they would otherwise be' will create instabilities. Which means before this cyclical bull market is over we will see another very volatile period like 2010.

Make no mistake however, excess liquidity and speculation does not equal economic activity. It will amplify stock market signals (rallies) based on economic growth (which there is), but will also amplify downturns when said growth stalls (and it will). Feedback works both ways, as any signals engineer will tell you.

QE, while not inflationary, potentially creates excess liquidity (see my scenario above) and certainly creates excess speculation which acts like an amplifier. Which means that there exists the increased potential for instability. And I don't think many people are appreciating that fact.

For some thoughts on how that could manifest, see this: Bear Market Momentum Internals: Examination of Moving Average 'Price Stretching'

13 Comments – Post Your Own

#1) On February 02, 2011 at 9:05 AM, MoneyWorksforMe (< 20) wrote:

Binve,

"The only way for Quantitative Easting to be inflationary is if all of these new bank reserves spurred an increase in lending, and that is not happening."

I have two problems with your theory of why QE is deflationary rather than inflationary...

How can you make this conclusion based on lending alone? Who's to say the banks are not buying up other riskier assets such as equities with the excess liquidity from the fed? If the fed keeps buying their treasuries and the dollar keeps losing value, this will drive A LOT of money into high yield bonds, stocks, real estate etc...

The larger of the two problems I have with your theory is the fact that the fed's balance sheet continues to expand. The fed doesn't have an income, so what does it do? Print money. I think inflation would be more readily seen if you viewed it in terms of assets held by major U.S. banks and institutions, including the fed. The fed's balance sheet has increased by a factor of five since 2008, from ~$750bill to nearly $4 trill.! In a world where the fed couldn't print money, this would mean some other institution or an aggregate of institutions would have seen a decrease in financial assets by a factor or 5 over that same time frame...But the fed printed money and supplanted non-performing toxic financial assets, with cash, that could then be used by these same pathetic financial company's to buy up other risky assets...

The only way for QEII to be disinflationary is if these banks decided to keep the cash they have received in exchange for their treasuries, in the form of dollars. With capital reserve requirements already being met, and the dollar consistently losing value, what bank is going to keep all of these extra dollars on their balance sheet without putting them to work in high yield assets? None.

The big banks know the fed wants to inflate, not simply because it said it wants to, suddenly changing its mandate, but because how the hell can the U.S. pay its $14tril. national debt without inflating!?

What you have here is asset and commodity prices from corn cotton and oil, to industrial and precious metals, to U.S. and foreign equities, being bid up to the sky...In other words widespread, high inflation in commodities and financial assets...

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#2) On February 02, 2011 at 9:48 AM, binve (< 20) wrote:

MoneyWorksforMe ,

>>How can you make this conclusion based on lending alone? Who's to say the banks are not buying up other riskier assets such as equities with the excess liquidity from the fed?

I went through the thought process above.

Bank reserves have increased, but bank reserves cannot be used for speculation. Bank reserves are on account at the Fed and can be used to purchase Treasuries, MBS's, or loaned interbank to those that need it for reserve requirements. This is true for all commercial banks, investment banks, primary bond dealers, or other government securities dealers who have an established trading relationship with the Fed.

So based on that, we have to understand in what context an increase in reserves can be inflationary

1) If banks are the ones selling Treasuries / receiving increased reserves, then the only way it becomes inflationary is through an increase in lending (via the Money Multiplier). I showed above why that is not likely (since the banks can't speculate with the reserves)

2) If bond holders are selling treasuries though primary dealers to the fed, then primary dealers get reserves (again, can't be used to speculate with) and the bond holders will get cash. But this is not arbitrage (since reserves only yield 25 bp and 10 year treasuries yield 348 bp), so this would at best be a carry trade (via the repo market) like I describe above. And eventually carry trades have to be unwound.

>>The larger of the two problems I have with your theory is the fact that the fed's balance sheet continues to expand. The fed doesn't have an income, so what does it do? Print money.

It will receive income from the Treasuries that it buys. Remember, QE is an asset swap. The Fed is take treasuries ('high' yield) out of the private sector in return for reserves ('low' yield) and putting the treasuries on its own balance sheet. It is taking interest bearing assets out of the economy.

So QE is deflationary initially, and if the banks can't put those reserves to work (and I explained why that is unlikely above) as the basis for generating new loans [not for speculations, reserves can't be used that way) then it's inflationary potential will not be realized.

Many speculation scenario above is just that. No new money supply => chasing same amount of assets => speculative price rise (bubble).

>>has increased by a factor of five since 2008, from ~$750bill to nearly $4 trill.! In a world where the fed couldn't print money, this would mean some other institution or an aggregate of institutions would have seen a decrease in financial assets by a factor or 5 over that same time frame...But the fed printed money and supplanted non-performing toxic financial assets, with cash, that could then be used by these same pathetic financial company's to buy up other risky assets...

You are misunderstanding the point of my post. I am not saying that previous actions by the Fed are not inflationary.

They are! Undoubtedly so! Wall St. bailouts and purchase of non-performing MBS's are demonstrably inflationary.

And I fully expect inflation to continue in the future. The USG has made sure that inflationary policies will remain in place.

But the point of this post is to answer: Is QE-II inflationary or likely to result in inflation?

The answer I come up with is no.

I am quite sure we will have inflation in the long term, but it won't be because of QE-II (and QE-III if it is structured the same way as QE-II)

This is why I say:

My main point here is that in all three of these cases, there has been a sharp increase in risk asset prices across the board (many different asset classes) with no commensurate increase in the money supply

Both the nature (severity) of this rally and its timing scream 'speculation' to me.

Now please, don't misunderstand what I am saying. Excess liquidity and/or the urge to speculate does not guarantee a rally. There has to be some basis for speculation, and with stocks in particular, all of dominoes did in fact line up:

a) There had to be actual GDP growth occurring (which there has been)
b) Earnings has to be growing (and they have been)
c) Corporate balance sheets had to be improving (and they did)

There are some legitimate reasons for investors to be bullish right now, and I am saying that part of the rally is for that reason. But how it has manifested, and how the market reacted in all risk assets, not just stocks, to the QE hints and then the official announcement has a speculative stench all over it...

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#3) On February 02, 2011 at 10:03 AM, MoneyWorksforMe (< 20) wrote:

Just one more important point:

Looking at bank lending over time is a poor way to project inflation in this environment...

Why?

Because the major financial institutions understand that the fed wants to significantly devalue the dollar in order for the U.S. to be able to pay back its debt. If banks believe the dollar will lose significant value going forward why would they want to make a loan to someone only to get back significantly depreciated dollars in the future? In nominal terms, banks will lose money or make very modest returns by making loans to credit worthy borrowers. Banks much rather buy commodities, equities and real estate than make loans, simply because it is much more profitable...

The U.S. government's fiscal mess is trumping efforts by the fed to spur lending...

 

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#4) On February 02, 2011 at 10:12 AM, binve (< 20) wrote:

MoneyWorksforMe,

>>Banks much rather buy commodities, equities and real estate than make loans, simply because it is much more profitable.

I am not arguing that they won't.

I am saying that can't do that with the extra reserves they will get as part of QE-II. See my response above.

I am not saying that the long term outcome of US monetary policy is not inflationary. It is. I am saying that QE is not inflationary.

QE will not lead to persistently higher money supply => persistently higher prices. Other monetary activities might be inflationary, but not QE..

This is why specualtion based on an inflationary QE expectation is just that, speculation. And all speculative bubbles end the same way.

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#5) On February 02, 2011 at 10:25 AM, MoneyWorksforMe (< 20) wrote:

 Binve,

I now see our point of misunderstanding based on this statement... 

"But the point of this post is to answer: Is QE-II inflationary or likely to result in inflation?"

I understand where you are going with this, but I can't help but perceive this question as trivial because of the current economic context...In other words it can be said that: QEII itself, is not inflation, but the economic actions and responses it sets into motion are. There is no need to be tentative with the wording of your question...There is absolutely no doubt, that given this current economic context, QEII yields inflation...

As an aside Binve, I appreciate and read most--if not all of your posts--you are a great asset to the fool community...


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#6) On February 02, 2011 at 10:30 AM, binve (< 20) wrote:

MoneyWorksforMe,

>>I understand where you are going with this, but I can't help but perceive this question as trivial because of the current economic context...In other words it can be said that: QEII itself, is not inflation, but the economic actions and responses it sets into motion are. There is no need to be tentative with the wording of your question...There is absolutely no doubt, that given this current economic context, QEII yields inflation

I am really doubtful of this.

But at the end of the day (based on my long term investment thesis) I don't much care. I am invested in real assets since I believe the bull market in them is far from over. So if QE turns out to be inflationary, or if there is a speculative hiccup, I think the long term trends are intact.

I just wanted to sound the speculation bell becuase I think there is a lot of evidence for it and I think a lot of people are not considering it.

>>As an aside Binve, I appreciate and read most--if not all of your posts--you are a great asset to the fool community...

Thanks man, I appreciate that!..

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#7) On February 02, 2011 at 7:17 PM, whereaminow (24.34) wrote:

binve,

I only have time to skim this right now, but I want to give you props. You appear to have brought in views from every angle in an attempt to create a unified understanding of the events in question.

I hope I have some time this week to read this (two or three times) and offer some commentary. This is like going back to school!

(Btw, have you thought about taking any of the online classes over at Mises U? The feedback has been positive (I like to let other people be the guinea pigs). I've been considering it, but I barely have time for this!)

David in Qatar

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#8) On February 02, 2011 at 8:01 PM, binve (< 20) wrote:

whereaminow ,

Thanks David!

>>You appear to have brought in views from every angle in an attempt to create a unified understanding of the events in question.

That was definitely my intention. Thanks :)

>>(Btw, have you thought about taking any of the online classes over at Mises U? The feedback has been positive (I like to let other people be the guinea pigs). I've been considering it, but I barely have time for this!)

I have thought about it, but like you I am already quite busy, I barely have time for this as well :).

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#9) On February 04, 2011 at 11:42 AM, ikkyu2 (99.24) wrote:

You've neglected to account for the purpose of bank reserves, which is to cover in the event of defaults.  Banks' 'assets' aren't like your assets and my assets.  I own a home; the bank owns my note of hand promising to pay off the mortgage.  That note's value is on the bank's balance sheet as a AAA asset. 

Bank has to hold reserves to cover for defaults.  If a lot of defaults occur, that notional money that was created into the money supply - pulled forward from my future earnings - when I signed my note?  It suddenly disappears from the money supply.  That's a deflationary influence.

As you properly point out, buying a T from the Treasury takes money out of the money supply today; (whilst coupon payments on old Ts put money into the money supply.)   When the Fed swaps cash (into reserves) for T's (that it takes out of circulation), that is countering the deflationary influence.

You can say that countering a deflationary influence isn't the same as inflating, but it all depends on what you're calling zero.  The collapse of the world financial system, followed by a return to a hard money economy and the total inavailability of any credit, would be hugely deflationary. 

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#10) On February 04, 2011 at 1:53 PM, binve (< 20) wrote:

ikkyu2,

This is a very good point and train of thought. I am going to describe the mechanics so that I am not talking generalities.

When a bank makes a loan, money is created horizontally (within the banking system). The loan instantaneously increases the bank's assets and liabilities without affecting reserves or captial. Let us assume that the bank doesn't have the required reserves to back the loan at the time of issuance (and as I point out above, that is almost always the case. Banks make loans first and then try to find reserves on the interbank network). So the bank tries to look for reserves, either interbank or at the discount window. Either action would put upward pressure on the Federal Funds rate (assuming there are no additional reserves in the system => reserves are already back outstanding loans and this transaction needs reserves that don't yet exist).

Since one of the Fed's mandates and it's primary reason for existence is to control the Fed's funds rate, the Fed needs to add reserves to the system to lower the Fed funds rate back to its target. The way it does that is by buying Treasuries (which is almost always done via OMO). Treasuries are bought by the Fed (either directly from the Treasury via new issuance or from PDs or Gov Sec Desks or from banks from existing stock) which pays by adding reserves. Reserves are then redistributed to the bank in need though either the interbank network or the Discount window.

The point of this is to show how the reserves come into existence. Their reason for existence is to manage the Fed Funds rate and to maintain reserve requirements as set forth by the Fed. However it is worth pointing out that there are many banking systems (such as Canada) which have no reserve requirements.

They may have a second reason for existence which is to cover a bank in the case of a default, as you point out. Let's examine that sceanario.

First, instead of a loan defaulting, lets say a loan matures. The loan gets taken off the bank's book reducing both assets and liabilities. That bank finds that it has more reserves than it needs, since its outstanding loan pool has shrunk. The bank does not want idle reserves sitting on its balance sheets (which used to pay nothing, but now pay 25 bp). It will trying to sell them on the interbank network. At this moment, there are more reserves in the system than is necessary. This puts downward pressure on the Feds Funds rate. In order for the Fed to maintain its target rate, it will sell to the banks Treasuries from its portfolio. Banks buy the Treasuries (earning a higher rate of return) from the Fed in exchange for the reserves (which drains reserves from the banking system). This action by the Fed maintains its target rate.

Before we get to the default issue, it is worth nothing now that the current Fed funds rate is 0 (well 0-25 bp), but effectively zero. The Fed purposefully wants it target rates to stay low, so in this environment the Fed will not sell Treasuries from its porfolio for the surfeit of reserves. This means banks will keep reserves on their books even though they have more than what is required.

This goes with the scenario I layed out above. The Fed thinks that by letting excess reserves build up in the system, it can increase lending (as banks will trying to make a loan to be backed up by the excess reserves it currently holds). But this is erroneous, because like I point out, banks are never reserve constrained to begin with. The manipulation of reserves is changing the supply side of the equation. The demand side (the private sector's willingness to borrow) is still low since it's balance sheet remains in such bad shape. It doesn't want to take on more debt.

But back to the comment at hand

So now, instead of a loan getting retired, it get defaulted on. Just like with retirement, a defaults affects a banks assets and liabilities. But the bank no longer has any future expectation of income based on that liability, and must use its reserves to cover its deficit, so that it stays solvent and maintains its captial requirements.

How would the system respond?

Lets say the bank did not have reserves necessary in order to remain solvent (the extreme example).:

a) It could pay for the reserves by selling part of its Treasury portfolio. But it is insolvent, so by definition it does not have enough.
b) It could borrow over the interbank network, but what solvent bank would lend to one that is insolvent?
c) It could get 'bailed out' by the Fed. The Fed would loan / give reserves to the insolvent instiution
d) We could change the accounting rules so that the bank didn't have to foreclose to begin with and could keep non-performing loans on its books as performing [wait, we already did that]
e) The insolvent back would go into receivership

So your observation:[ If a lot of defaults occur, that notional money that was created into the money supply - pulled forward from my future earnings - when I signed my note?  It suddenly disappears from the money supply.  That's a deflationary influence. ] is absolutely correct.

That makes this observation [ You can say that countering a deflationary influence isn't the same as inflating, but it all depends on what you're calling zero. ] another very interesting point, and I am inclined to agree up to a point.

I am saying it is not inflationary for the reasons that many other say QE is inflationary, which goes like: The governement is printing money to buy Treasuries, which increase the money supply which causes inflation. Because the whole point of my post was to show why that path of causality is erroneous.

I still maintain QE is an asset swap (no new net assets added to the financial system), and unless the addtional reserves spur an increase in bank lending, then it is inflation neutral and technically slightly deflationary (since interest income from the Treasurys is diverted to the Fed vs. the private sector).

However, your more nuance view of what is actually being replaced is exceptionally valid.

QE is taking perfectly 'good' Treasuries to place reserves into the banking system to protect against a wave of upcoming defaults (which would be otherwise highly deflationary). In this case, I agree that QE is inflationary because it is preventing a deflationary adjustment from taking place.

I was disproving the supply side [money multiplier] inflationary argument, but your argument proves that QE is not quite as neutral as my post suggests.

Very good comment, thanks for making it!..

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#11) On February 05, 2011 at 4:59 PM, Option1307 (29.96) wrote:

Great post Binve,+1!

TPC has several great articles along these same lines, but it's nice to see your take on things as well. Your writting is always clear and concise and continuously gives me something to think about, so I thank you for that!

I am by no means an expert in all of this and can't really make an argument one way or anthoer as to whether QE is inflationary etc.; however, I must say that it is nice to read such a well thought out (and logical) explanation for why it is not. Regardless of one's own opinion, this topic sure doesn't get discussed in the maion stream media or anywhere else really so I definitely believe that far too many people fail to understand what is truly occuring.

Thanks again!

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#12) On February 07, 2011 at 4:37 PM, binve (< 20) wrote:

Option1307,

Thanks man!

I was trying to stay away from misleading phrases and hyperbole (which I admit I have been guilty of using), and trying to think through the issue based on simply the fundamentals. And this is the conclusion that I am led to.

Many are claiming that rising food and energy prices are 'proof' that QE is inflationary. I find that assertion highly suspect. Like I write above, the rally was sparked in many risk assets, not just food and energy and speaks much more to speculation IMO...

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#13) On February 21, 2011 at 4:14 AM, ikkyu2 (99.24) wrote:

You know, the next step in this argument is to talk about supply and demand.  We usually like to think about goods when we talk about supply and demand, and how they are exchanged by purchases; but money has a supply and demand too, and credit, not purchases, is the mechanism by which those transactions occur.

The point of supply and demand is that, given market incentives, transactions 'seek their own level' - prices and quantities set themselves in such a way as to maximize efficiency.  Now, let's play Stalin, set prices, and fix output quotas.  Results: grain rots in silos while trucks and tractors sit idle for want of spare parts: country-wide famine.  Total inefficiency.

Let's play Bernanke, counter a deflationary influence, and set bank lending quotas and rates.  Result: stocks like MGM and LVS go up as money that shouldn't be in the system moves through the system at an artificially elevated velocity.  Commodities like irreplaceable petroleum are used in projects for whose ultimate end there will be no demand; or, worse, wasted ferrying tourists around the highways, tourists who wouldn't have had a job had this goofery not been perpetrated.

Look at the price of gasoline.  Is that justified by aggregate output of the world economy right now in 2011?  Hell no. 

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