QE dynamics one more time- it’s about price, not quantity
Written by: Warren Mosler
Believe it or not I’m still getting a lot of questions about how QE works,
so I’ve reorganized the discussion some:
First, recognize that, In fact, reserves, functionally, are nothing more than 1 day T bills.
And, for all practical purposes, the difference between issuing 1 day t bills and 3 month T bills is inconsequential.
So since currently the shortest thing the Treasury issues are 3 mo bills,
I can say that:
QE- the Fed buying longer term treasury securities- is functionally identical for the economy to the Treasury having issued 3 month t bills instead of those longer term securities the Fed bought.
Now the more tricky part.
The yields on the approx. $13 trillion of various Treasury securities and reserve balances continuously gravitate towards what are called indifference levels.
That means that for any given composition of reserve balances at the Fed and Treasury securities (also Fed accounts), there is a term structure of interest rates that adjusts to investor preferences at any given time.
So, for example, with govt. providing investors with the combination of $2 trillion in reserves and $11 trillion in various Treasury securities, the yield curve will reflect investor preferences given the current circumstances.
That means if investors expect Fed rate hikes, the front end of the curve would steepen accordingly. And if instead they expect 0 rates for a considerable period of time, the curve would flatten for the first few years to reflect that.
If the Fed then buys another $1 trillion of securities, reserves go to $3 trillion and there are $10 trillion longer term Treasury securities outstanding.
And to actually purchase those reserves, the Fed would have to drive the term structure of rates to levels where investors voluntarily are indifferent with that mix of offerings, given all the other current conditions.
The Fed doesn’t force anyone to sell anything.
It just offers to buy at prices (interest rates) that adjust to where people want to sell at those prices.
So even if the Fed owned a total of $10 trillion of securities, and there were only $3 trillion left outstanding for investors, if investors believed the Fed was going to hike rates by 3%, for example, the term structure of rates on Treasury securities would reflect that.
What I’m trying to say is that QE does not mean rates will actually go down. The yield curve is still a function of investor expectations.
But the yield curve is also a function of ‘technicals.’
This means the quantity of 30 year securities offered for sale, for example, can alter the yield of that sector more than it alters the yields of the other sectors.
This is because, in general, there tends to be fewer ‘natural’ buyers of 30 year securities than 3 month bills.
For most of us, we are a lot more cautious about investing for 30 years at a fixed rate than for 3 months at a fixed rate.
And it takes relative large moves in 30 year rates to cause those investors to shift our preferences to either buy them if govt. wants to issue more, or sell them if the Fed wants to buy them back.
On the other hand, there are pension funds who ‘automatically’ buy 30 year securities regardless of yield because they are matching the purchases to 30 year liabilities.
So altogether, the yield curve is function of both investor expectations for interest rates and the ‘technicals’ of supply and demand (desires by issuers and investors).
And while there might be no amount of 3 month bills the Treasury could issue that would materially drive up 3 month t bill rates, relatively small amounts of 30 year bonds do alter the yields of 30 year securities. Insiders would say the 30 year market is a lot ‘thinner’ than the 3 month market.
So what is QE?
QE is nothing more than the govt. altering the mix of investments offered to investors.
The Fed buying longer term securities reduces the amount of longer term securities and increases the amount of reserves (one day securities)
Interest rates, as always, continuously gravitate to reflect current investor expectations of future Fed rate changes and current ‘technicals’ of supply and demand.
QE changes the technicals, and possibly expectations, and results in a yield curve that reflects those current conditions.
So all QE does is alter the term structure rates, as investors express preferences for the term structure of interest rates, given the securities and reserves of the varying maturities offered by the Fed and Treasury and all the current conditions.
That brings us back to the question of what QE means for the economy, inflation, value of the currency, etc.
Which comes down to the question of what the term structure of rates means for the economy, inflation, the value of the currency, etc.
QE is nothing more than a tool for changing interest rates by adjusting the available supply of securities of various maturities (technicals). And it’s not a particularly strong tool at that.
It’s the resulting interest rates that may or may not alter the economy, inflation, and the value of the dollar, etc. and not the quantities of reserves and Treasury securities per se.
And it is clear to me that the FOMC does not fully understand this.
If they did, they’d be in discussion with the Treasury about cutting issuance.
And, additionally, If they wanted the term structure of interest rates to be lower, they would simply target their desired term structure of rates by offering to buy unlimited amounts of Treasury securities at their desired rate targets, and not worry about the mix between reserves and Treasury securities that resulted. Which is what they did in the WWII era. And how they target the fed funds rate.
With today’s central banking and monetary policy with its own currency, it’s always about price (interest rates) and not quantities.