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Beyond the hype, a beginner’s guide to QE

Many writers of opinion pieces have discussed what tapering of the Federal Reserve’s (Fed) Quantitative Easing (QE) might mean for investment markets. This article looks at the more basic questions: what is ‘QE’ and what does ‘tapering’ mean?

QE is not ‘printing money’. They are close cousins, so don’t hang, draw and quarter anyone for confusing them, but they are different in some important ways. Printing money happens when governments run deficits and central banks simply create the cash that governments spend in excess of revenues without the need to issue government bonds. This is also called ‘monetising the deficit’. Central banks are not currently doing this. QE is in fact independent of the budget deficit and in theory could be undertaken even if the budget was in surplus.

However, the context in which QE has been implemented is a budget deficit. This is how it works.

The budget deficit is funded by the sale of bonds to the market. Money is thus taken out of the economy as the private sector pays for these bonds. However, central banks put money back in, by purchasing long dated assets from the market. These assets include, but aren’t limited to, government bonds. For example, the Fed in the US has also bought residential mortgage-backed securities, while the Bank of England bought some corporate bonds.

This is where the Q part of QE comes in. The instrument of the policy is to buy a pre-announced quantity of assets. Currently the Fed is targeting US$85 billion per month. The target quantity of assets is bought at the market price. By standing as a large source of demand, the intention is to increase the price (reduce the yield) of these assets compared to what it would otherwise have been, but with QE a specific yield is not set by the central bank.

Signs of success

The evidence suggests that central banks have been successful in this goal. Dr Min Zhu, the Deputy Managing Director of the International Monetary Fund, said in a speech at the Australian Business Economists conference held on 21 November that the impact in the US has been a 1% reduction in long bond yields. He put the impact in the UK at 0.5%.

Therefore, QE changes the composition of private sector assets. Banks hold less in bonds and more cash. Unless the private sector actually boosts its borrowing or spending by putting the cash to work, the funds invested by the central bank will just sit in bank reserves. The increased money supply doesn’t automatically mean that there is more lending in the economy. This is one of the reasons the Fed included mortgage-backed securities in its QE program, as that provided a more direct policy support to the beleaguered housing sector in the US. However, overall it is up to the private sector to decide how QE transmits to the broader economy.

Although QE is called ‘unconventional’ monetary policy, buying bonds from the market is not unusual at all. The main difference from what central banks do when they are easing policy in normal times is simply that they have a quantity target rather than a yield target.

In normal times, central banks go to the markets to buy short term securities in order to drive the cash rate lower. This is the conduct of open market operations. When the cash rate approaches zero, as it has in most Western economies, this cannot reduce money market rates any further. However, by QE, central banks try to reduce yields across the maturity spectrum. Lower long term yields are an incentive to the private sector to borrow more or to invest in riskier assets.

The intention of easy monetary policy, whether conventional or not, is to create stronger economic growth without generating excessive inflation. There is always a debate about whether policy is being run ‘too easy’, but the underlying growth rate of many economies – the US, UK, Japan and others – has been so weak, and the risk of inflation so low, that their central banks have chosen to provide additional support beyond zero cash rates.

The other difference from open market operations is that QE results in an increase in the central bank’s balance sheet. The assets of the Fed have increased dramatically since the commencement of QE, as the following chart shows:

WB Fed

WB Fed

The first surge was in late 2008 when they purchased mortgage-backed securities. For a brief time in mid-2010 QE was stopped, but when the economic data continued to be weak the Fed announced in August 2010 that it would buy US$600 billion of Treasury bonds by June 2011. This second round became known as QE2.

Continued economic underperformance led to a step-up in the programme, this time leaving its size open-ended. QE3 was initially US$40 billion of securities per month, and then was increased to the current US$85 billion in December 2012.

Unwinding QE

At some point, when economic recovery is more self-sustaining, QE will need to be wound back. What will that involve?

Step 1 is tapering. This is simply a reduction in the quantity of assets that are purchased. The Fed believes, rightly in my view, that tapering is not the adoption of tight policy. It is reducing the amount of stimulus, but even a reduced program of QE is still providing liquidity to the private sector. The Fed has indicated that its judgment about how rapidly to taper the programme will depend on the performance of the economy.

Step 2 is a decision about what to do with the enlarged balance sheet once purchases cease. Will they simply let bonds run off and allow the balance sheet to return to a more normal size gradually? Or will they actively sell bonds out of their portfolio to reduce the balance sheet more quickly? Either way, it will take a long time before the Fed’s assets returns to ‘normal’. Dr Zhu from the IMF suggested a timeframe of at least 10 years.

Many analysts fear that the unwinding process will be disruptive. Some use emotive imagery, likening financial markets to a drug addict dependant on QE, and the unwinding process to the pains that an addict experiences when they start to kick their habit.

While that sort of language is over the top, there is no doubt that past episodes in which easy monetary policy has been turned around have seen higher bond yields and weaker equity markets. It’s understandable that many forecasters see markets behaving the same way when QE ends.

However, when forming your own view on the outlook for market, I hope you’ll keep in mind that QE is really only a form of easy monetary policy. A lot of the hyped-up commentaries you see around the place seem to suggest it is a dark art that has introduced all sorts of abnormalities into the world economy and that it can only end in tears. I hope that this article has put QE into a more sober perspective.

Warren Bird was Co-Head of Global Fixed Interest and Credit at Colonial First State Global Asset Management until February 2013. His roles now include consulting, serving as an External Member of the GESB Board Investment Committee and writing on fixed interest, including for KangaNews.

Warren Bird
June 18, 2019

With the talk about the RBA making the case for QE in Australia, thought it might be worthwhile bumping this up.

June 19, 2019

Very good Warren, it does appear more than just a theory now for Australia.

Warren Bird
December 19, 2013

Hi Rick,

"the market" is anyone who owns Treasury bonds or the other assets that the Fed purchases. The Fed deals directly with a group of banks, but those banks could be selling to the Fed bonds they own themselves, or broking a sale on behalf of their clients who are happy to sell from their holdings.

(This is similar to when a fund manager wants to buy bonds for their portfolio. They go to a bank to do a deal; that bank might sell from their own inventory or they might go to other counterparties to get them. The process of having intermediaries such as the banks is what brings all the different buyers and sellers of securities together so that transactions can take place.)

The bonds that the Fed has been purchasing have a variety of maturity dates and have been transacted at many different yields. Over the time the Fed has been doing QE, US bond yields have traded between around 1.4% and 3%. Every month the Fed has bought the amount it wanted to at whatever yield was trading in the market at the time. For a period in 2011 they also changed the maturity of their holdings by going to the market to sell bonds maturing in less than 3 years and buying bonds with maturities from 6 to 30 years. (This was known as Operation Twist.)

The Fed is not supplying money to the market for next to nothing. It's a commercial transaction. The market has bought bonds from the US Treasury and then sold them to the Fed at the current yield, which is based on all the other billions and billions of transactions in bonds and other interest rate securities every day. Sometimes the holders will have made a short term gain, sometimes they will have made a short term loss. In all cases they have given up an asset yielding well above the interest rate they are earning on the cash that they get paid. The point of QE is to get cash into the banks that they can then lend to consumers and businesses.

The idea that the money isn't getting out to 'real world' investors crops up a lot. One thing to understand is that monetary policy - whether it's the 'normal' policy of changing the cash rate like the RBA is still doing, or QE - only ever is a method of persuasion, not coercion. The RBA cuts the cash and hopes/expects that this will result in more borrowing for real economic activity. But if the economy is weak and confidence low, that mightn't be enough and they have to cut again. The judgment the RBA Board makes every month is whether the current level of the cash rate is producing the macroeconomic outcomes they want. If it is, then they say that the current setting is "appropriate". If it isn't, then they change the cash rate.

QE operates when a zero cash rate is proving to be insufficient to generate stronger economic activity. The central banks try to encourage more credit creation by outright bond purchases. But they aren't there to pick the loans to be made, or to force anyone to borrow if they don't want to. They make the liquidity available, try to make yields on longer term borrowing as cheap as possible, and let the real world participants make the ultimate decisions.

In my view it has worked. The Bank of England has estimated that UK economic growth is about 1.5% stronger than it would have been without its QE program. I think the US housing market wouldn't have recovered as strongly as it has without the Fed buying all those mortgage-backed securities, so the US economy has benefited.

It's true that a lot of the cash that the banks have received from their bond sales to the Fed is just sitting in reserves and hasn't been loaned out. That's not necessarily because the banks won't lend, it's because the economy has been deleveraging and borrowers have been reducing their gearing. As I said, monetary policy is only ever able to provide an environment conducive to credit creation, but they can't force the issue.

The Fed has this morning announced a modest tapering of QE, back to $75 billion a month. They've done this because they see signs that the US economy has begun to improve on a more sustainable basis, so it doesn't need quite as much stimulus. Personally I don't believe that this improvement would have happened without QE, so I think it's working. It hasn't worked as fast as everyone would have liked, but that isn't the fault of QE. It is simply a reflection of how bad the underlying economic fundamentals have been and how steep the hill has been up which QE has been pushing. We all hope that the top of the mountain is being reached and that the world can get through this disaster that the GFC has been. But we wouldn't be as close to that point if central banks hadn't run easy monetary policy.

The one thing we do know is that there is now a lot of liquidity that can be put to work when real world agents have investment projects and new businesses to create, and the confidence to borrow to fund them. That is when the money supply will really grow and the Fed will have to be on its toes to reduce the stimulus at the right rate so it doesn't just turn into inflation. It will be a good problem to have, I think.

On your final point, the central banks don't have to repay the debt - the Government does. The central banks have chosen not to merely "print money" because to do so would take away from Governments the discipline of having debt on their books that they have to pay back. As I said in the article the conduct of QE is independent of the size of the budget deficit or the government's total debt level.

Of course, the Fed and other central banks will believe that their governments have a plan to reduce debt levels over time. QE is part of the plan because the best way for governments to get debt down is go support economic growth, which generates the taxes they need in the future to pay their debts. But that is taking us into another huge topic, beyond the scope of this piece.

If you want another respected opinion on all this, I recommend Shane Oliver's article for the ASX which you can find here:

I hope all this helps.

Rick Cosier
December 18, 2013

Warren, thank you for attempting to explain QE, but I don’t really understand it. Perhaps you can enlighten me a bit more.

You mention that the Fed is selling bonds to the market. Who exactly is ‘the market’, when do the bonds mature and what interest rates are involved? When the Fed purchases longer dated bonds later, who do they buy them from and at what price? The impression is that the Fed is supplying money to ‘the market’ for next to nothing, and ‘the market’ invests the money back into US bonds thereby making a tidy arbitrage with absolutely no risk. Consequently, very little of the money is actually being lent to bone fide ‘real world’ investors, which is doing nothing to stimulate the economy.

Furthermore, US debt levels total trillions of dollars which equates to a stratospheric percentage of GDP never before seen. Can you tell me how the central banks expect to repay this debt? Is there a plan, or are they just hoping everything will turn out all right?

Jim Wright
December 14, 2013

I enjoyed the article.

Sandy Calder
December 14, 2013

Thanks for your well written, useful article Warren


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