Even though the Federal Reserve does not have the power to raise asset prices, investors continue to cram into stocks since they believe the Fed has some mythical power to raise stock prices. The psychological effects of Quantitative Easing (QE) are all the Fed needs since it has brought investors back into the market who are bidding stock prices higher. Just like going into the Great Financial Crisis, QE will not work, since it does not do much of anything.
The Fed is trying to fix the dollar shortage it created when it contracted the number of dollars in the global economy, which led to a contraction in the global trade cycle, or World Dollar Liquidity (WDL). As you will see, the Fed has the power to destroy dollars, but it does not have the power to create them. It can only encourage the creation by lowering interest rates and hoping consumers and businesses borrow, which is how new dollars are created.
The WDL cycle exists since the dollar is the world’s reserve currency. The cycle starts when Americans buy foreign-produced goods and services, which sends dollars abroad. Foreign companies exchange those dollars to their bank, and in turn who exchange them with their central bank, for local currency. As dollars pile up at the foreign central bank, they create inflation, which is why the U.S. is a large exporter of inflation.
To reduce the inflationary effects of holding too many dollars, the foreign central bank purchases U.S. Treasury Bills, Notes, and Bonds at one of the regular U.S. Treasury auctions. The Federal government, who must run a deficit to provide government debt for foreign banks to exchange their dollars with, then spends the proceeds from the auctions into the real economy. Once the dollars are back in the hands of American consumers and businesses, the cycle repeats.
The WDL cycle creates dollars and inflation but the Fed does not control the creation of dollars since the cycle must start with Americans buying foreign-produced goods and services. The Fed does not have the power to make people spend money. When the Fed tightens monetary policy, it destroys dollars which leads to a contraction in WDL. This is the reason there is always an economic slowdown, recession, or depression after every Fed tightening cycle.
By lowering interest rates, the Fed is trying to encourage Americans to borrow and spend. When lowering interest rates does not work, the Fed engages in QE as it tries to replace the key component in the WDL cycle – foreign central banks buying U.S. government debt. By buying U.S. Treasuries, the Fed tries to make up for the reduction in government debt purchases by foreign central banks. But it does not work since the Fed cannot print money.
When the Fed buys U.S. Treasuries, it purchases them from the large commercial banks who are then required to take the cash it receives from the Fed and hold it in deposit at the Federal Reserve banks. The commercial banks cannot spend the money they receive from the Fed, but they can lend against it if they so choose to. Since the commercial banks must keep the cash from the sale of Treasuries on deposit at the Federal Reserve banks, it is not money printing.
Unlike the WDL cycle where foreign banks buy Treasuries and the Federal government can spend it, nobody can spend the money from the Fed buying Treasuries. Nobody. The large commercial banks can lend against it, but they already can lend against their deposits, which is more than sufficient to meet their lending needs. The banks do not need or have a use for the cash from the Fed, so it becomes dead money sitting in deposit at the Federal Reserve banks.
All QE does is take U.S. Treasury securities from the banks and pile up dollars in deposit at Federal Reserve banks, which is why QE neither fixes the WDL cycle or creates inflation. QE causes short-term interest rates to fall since banks have access to an increasing amount of cash to lend against. When cash at banks is growing faster than demand for short-term loans, since banks will not back a long-term loan with cash, short-term interest rates fall or stay low.
QE lowers short-term interest rates and keeps them low. It does not cause stock prices to rise, cause inflation, or repair the damage done to the WDL cycle. The purpose of QE is to keep short-term interest rates low to encourage borrowing, and it also leads to lower long-term interest rates since long-term rates follow short-term rates.
It does much less than most investors and professional money managers believe it does. As long as investors believe it gives the Fed great mythical powers to raise stock prices it can work as investors bid stock prices higher. Once stock prices stop going up, the emperor will have no clothes, just like with every past stock market crash.