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The Atlanta Fed's macroblog provides commentary on economic topics including monetary policy, macroeconomic developments, financial issues and Southeast regional trends.

Authors for macroblog are Dave Altig and other Atlanta Fed economists.


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March 24, 2009


Careful with that language

No doubt about it. The decision last week by the Federal Open Market Committee (FOMC) to further expand its balance sheet by up to $1.15 trillion was momentous. But beyond that number, some commentators seem to have suggested that the FOMC took a qualitative leap into quantitative easing (QE):

Feds Use Quantitative Easing

Fed kept its target rate unaltered and intensifies quantitative easing

QE and the US

The last article above comes from BBC News, where it is made clear that the QE theme is associated with the addition of long-dated Treasury securities to the list of assets that the FOMC has specifically asked the folks at the Open Market Desk at the New York Fed to purchase on their behalf:

"We've now had two weeks of quantitative easing in the UK. But as far as the world's concerned, this is Day One. That's because, as of today, the quantitative easers have the US Federal Reserve on their team.

"The US central bank's announcement yesterday that it would start buying US long-dated Treasury bills as part of a nearly $1.2 trillion stimulus programme came as a shock."

OK, let's repeat. Like any balance sheet, the Federal Reserve's has two pieces, the liability side and the asset side. The FOMC statement was explicitly about the asset side—the quantity and types of assets the Fed intends to purchase. Quantitative easing, on the other hand, is about the liability side. As reader Fischer points out in a comment to our previous macroblog post on the Bank of England's balance sheet:

"The entire point of quantitative easing is to put assets into the economy that increase the money supply..."

That exact point was made by Chairman Bernanke back in January:

"The Federal Reserve's approach to supporting credit markets is conceptually distinct from quantitative easing (QE), the policy approach used by the Bank of Japan from 2001 to 2006. Our approach—which could be described as 'credit easing'—resembles quantitative easing in one respect: It involves an expansion of the central bank's balance sheet. However, in a pure QE regime, the focus of policy is the quantity of bank reserves, which are liabilities of the central bank; the composition of loans and securities on the asset side of the central bank's balance sheet is incidental."

Of course, some think that such "incidental" expansions are far from trivial. John Taylor, for one, has a different view (registration may be required to see full article):

"An explosion of money is the main reason, but not the only one, to be concerned about last week's surprise decision by the Federal Reserve to increase sharply its holdings of mortgage backed securities and to start purchasing longer term Treasury securities."

I don't think anyone should be dismissive of that concern, which makes item 3 of yesterday's joint statement from the Treasury and Federal Reserve particularly noteworthy:

"3. Need to preserve monetary stability: Actions that the Federal Reserve takes, during this period of unusual and exigent circumstances, in the pursuit of financial stability, such as loans or securities purchases that influence the size of its balance sheet, must not constrain the exercise of monetary policy as needed to foster maximum sustainable employment and price stability. Treasury has in place a special financing mechanism called the Supplementary Financing Program, which helps the Federal Reserve manage its balance sheet. In addition, the Treasury and the Federal Reserve are seeking legislative action to provide additional tools the Federal Reserve can use to sterilize the effects of its lending or securities purchases on the supply of bank reserves."

Let us be clear: We are not trying to characterize the recent Federal Reserve decision one way or another. But as the Bank of England's current strategy and the Federal Reserve Chairman's comments noted above clearly indicate, expansions of the asset side of central bank's balance sheet—"credit policy," if you will—are conceptually, and if sterilized operationally, distinct from quantitative easing. The public discussion will be greatly enhanced if we keep those distinctions at the forefront.

David Altig, senior vice president and research director at the Atlanta Fed, and Daniel Littman, economist at the Cleveland Fed

March 24, 2009 in Federal Reserve and Monetary Policy | Permalink

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"...If sterilized operationally...", and is the FED actually sterilizing its expansion of the balance sheet? How so? Pray tell.

Posted by: APB | March 24, 2009 at 06:02 PM

Bill Mitchell sheds light on that.
"What is quantitative easing?

Quantitative easing merely involves the central bank buying bonds (or other bank assets) in exchange for deposits made by the central bank in the commercial banking system - that is, crediting their reserve accounts. The aim is to create excess reserves which will then be loaned to chase a positive rate of return. So the central bank exchanges non- or low interest-bearing assets (which we might simply think of as reserve balances in the commercial banks) for higher yielding and longer term assets (securities).

So quantitative easing is really just an accounting adjustment in the various accounts to reflect the asset exchange. The commercial banks get a new deposit (central bank funds) and they reduce their holdings of the asset they sell.

Proponents of quantitative easing claim it adds liquidity to a system where lending by commercial banks is seemingly frozen because of a lack of reserves in the banking system overall. It is commonly claimed that it involves “printing money” to ease a “cash-starved” system. That is an unfortunate and misleading representation.

Invoking the “evil-sounding” printing money terminology to describe this practice is thus very misleading - and probably deliberately so. All transactions between the Government sector (Treasury and Central Bank) and the non-government sector involve the creation and destruction of net financial assets denominated in the currency of issue. Typically, when the Government buys something from the Non-government sector they just credit a bank account somewhere - that is, numbers denoting the size of the transaction appear electronically in the banking system.

Does quantitative easing work? The mainstream belief is that quantitative easing will stimulate the economy sufficiently to put a brake on the downward spiral of lost production and the increasing unemployment.

It is based on the erroneous belief that the banks need reserves before they can lend and that quantititative easing provides those reserves. That is a major misrepresentation of the way the banking system actually operates. But the mainstream position asserts (wrongly) that banks only lend if they have prior reserves. The illusion is that a bank is an institution that accepts deposits to build up reserves and then on-lends them at a margin to make money. The conceptualisation suggests that if it doesn’t have adequate reserves then it cannot lend. So the presupposition is that by adding to bank reserves, quantitative easing will help lending.

But this is a completely incorrect depiction of how banks operate. Bank lending is not “reserve constrained”. Banks lend to any credit worthy customer they can find and then worry about their reserve positions afterwards. If they are short of reserves (their reserve accounts have to be in positive balance each day and in some countries central banks require certain ratios to be maintained) then they borrow from each other in the interbank market or, ultimately, they will borrow from the central bank through the so-called discount window. They are reluctant to use the latter facility because it carries a penalty (higher interest cost).

The point is that building bank reserves will not increase the bank’s capacity to lend. Loans create deposits which generate reserves.

The reason that the commercial banks are currently not lending much is because they are not convinced there are credit worthy customers on their doorstep. In the current climate the assessment of what is credit worthy has become very strict compared to the lax days as the top of the boom approached."

Posted by: Felipe | March 25, 2009 at 11:25 AM

"The entire point of quantitative easing is to put assets into the economy that increase the money supply..." :)

Posted by: Kenny | March 26, 2009 at 12:06 AM

From quote above:
"central bank buying bonds (or other bank assets) in exchange for deposits made by the central bank in the commercial banking system"

Are those money by any means *locked* at the CB? I suppose not and therefore question the claim that the asset purchase is sterilized. If the new money stays at the CB that is more a reflection of banks not needing them.

Bank reserves are definitely liabilities for the CB, so to say that the liability side is not affected sounds strange.

Posted by: Johan | March 26, 2009 at 03:43 PM

APB -- I suspect your question is rhetorical, but in case not: For the week ending March 18 the balance sheet was about $2.1 trillion, the monetary base about $1.6 trillion. So a bit less than 1/4 has been sterilized.

That said, the balance sheet grew by $168 billion over the week, and bank reserves by $148 billion (the second largest increase ever). So not a lot of sterilization as of late.

Posted by: David Altig | March 26, 2009 at 05:43 PM

On March 19, 2001, the Bank of Japan issued a monetary policy known as quantitative easing, which stimulated the Japanese economy after the burst of the dot-com bubble. This was the "birth" of the term quantitative easing, even though I do not think it represented the actual birth of the concept. So happy belated birthday to quantitative easing, I guess.

Posted by: dan littman | March 26, 2009 at 05:54 PM

The point is that building bank reserves will not increase the bank’s capacity to lend. Loans create deposits which generate reserves. Bank lending is not “reserve constrained”. Thus, increasing bank reserves will not lead to an increase in bank lending.

The reason why commercial banks are currently not lending much is because they are not convinced there are credit worthy customers.
Quantitative easing is when the central bank purchases investment maturity bonds (or other bank assets) in return for bank reserves and involves no change in the net financial assets of the non-government sector.
I hope this help. Check also Bill Mitchell's blog
http://bilbo.economicoutlook.net/blog/?paged=2

Posted by: Felipe | March 27, 2009 at 12:05 AM

OK, *if* purchases are compensated by the Supplementary Financing Program issuing as much short-term debt, there is no effect on money supply.

Posted by: Johan | March 27, 2009 at 06:49 AM

Suppose the Fed decides to buy assets from depository institutions (eg commercial banks).
The Fed buys the asset (let us say worth $1000) from the bank and then makes a payment to the bank crediting the bank's reserve account by the same amount of the purchase.
What are the balance sheet entries? We can use T-accounts to reflect these changes.
First, for the Fed. The Fed increases its assets holdings by $1000 and at the same time its liabilities are increased by $1000.
Now, for the commercial bank. In the first step the bank sells the asset to the Fed in exchange for reserves. The Fed exchanges non- or low interest-bearing assets (which we might simply think of as reserve balances in the commercial banks) for higher yielding and longer term assets (securities or any other asset).
The commercial banks get a new deposit (central bank funds) and they reduce their holdings of the asset they sell.

(Recall that the government spends by creating deposits in the private banking system).

This is what happened during the financial crisis when the Fed decided to buy assets from the banking system. Banks started to have non-interest bearing excess reserves. They tried to lend them on the interbank market. This put a downward pressure on the overnight interest rate. Note that the Fed has to keep the overnight interest rate close to the target. To accomplish this, they started to sell bonds to drain reserves from the banking system and hit the ffr target. At some point they ran out of bonds to drain these reserves. What did the Fed do? They asked the Treasury to issue more T-bills to, basically, help the Fed drain the excess reserves.
Later on, they recognized that if they started paying interest on reserves that would put a 'floor' for the overnight interest rate.
This means that the overnight interest rate can not go any lower than the rate the Fed pays on them because banks will not lend reserves on the interbank market and accept a rate lower than the one that the Fed pays.

The point is that building bank reserves will not increase the bank’s capacity to lend. Loans create deposits which generate reserves. Bank lending is not “reserve constrained”. The reason why commercial banks are currently not lending much is because they are not convinced there are credit worthy customers.
Check also Warren Mosler' blog http://www.moslereconomics.com/

Posted by: Felipe | March 27, 2009 at 12:15 PM

It would be interesting to know exactly what the sterilization techiques are in this case.

To me, these are the options:
1. Paying interest on reserves.
2. A revival of the Supplimentary Financing Program that was unwinded a while ago:
http://www.ustreas.gov/press/releases/hp1275.htm

To me, technique 1 is not under the control of the Fed and technique 2 is for the future, so what we are watching now should be called QE. Feel free to correct.

Posted by: Johan | March 30, 2009 at 06:24 PM

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