The Mechanics of Quantitative Easing

Investors continue to believe monetary policy can raise asset prices and create inflation when there is no evidence to support it can do either. One of the most important aspects of monetary policy is belief. As long as investors believe monetary policy can raise asset prices and create inflation, they will invest accordingly, which in the short run, can lead to both.

In the long term, monetary policy cannot raise asset prices, cause stocks to magically rise, or create inflation. The Federal Reserve is a purpose-built institution designed to stop inflation. It was never given the tools, mechanism, or ability to create inflation since inflation was the problem when the laws governing the Federal Reserve were passed.

This week, I thought it would be helpful to break down the process of Quantitative Easing so you can see exactly why it is deflationary and not inflationary.

In the beginning, a large commercial bank will take cash to buy a U.S. Treasury Bill, Note, or Bond. Large commercial banks do not participate in the monthly U.S. Treasury auctions, so they must buy on the open market or a securities dealer, which they conveniently own. In this example, a large commercial bank purchases a Treasury Bill, Note, or Bond for $1,000. After the exchange, the U.S. Treasury is the net recipient of the $1,000 and the large commercial bank owns a U.S. Treasury Bill, Note, or Bond.

The Fed then announces due to liquidity and other concerns that they will engage in open market operations, or Quantitative Easing. Quantitative Easing is when the Fed purchases U.S. Treasury Bills, Notes, and Bonds from the large commercial banks. Continuing our example, the Fed buys a U.S. Treasury Bill, Note, or Bond from a large commercial bank at market price.

Let us assume the market price is static and the Federal Reserve pays $1,000 to a large commercial bank for a U.S. Treasury Bill, Note, or Bond. The Fed now owns a U.S. Treasury Bill, Note, or Bond and the large commercial bank has its original $1,000 back. Except the bank does not get the money to spend how they wish.

To make sure the Fed follows the Federal Reserve Act, which clearly states the Fed cannot print money, the $1,000 must be deposited in an account that prohibits withdrawals at one of the twelve Federal Reserve member banks. The only way a large commercial bank can get the money in the account back into the broad economy is to use it as collateral against a loan to one of its customers.

The process starts with a large commercial bank having $1,000 in cash. At the end of the process, the large commercial bank has $1,000 in an account at a Federal Reserve bank that it cannot withdraw from. The reason Quantitative Easing is deflationary is it takes a Treasury Bill, Note, or Bond away from the banks and in return, gives them a cash account they cannot draw from.

When a large commercial bank holds a Treasury Bill, Note, or Bond, it can hold them, lend against them, or sell them to generate cash. With the money tied up in an account they cannot draw from, all a large commercial bank can do with the money is use it as collateral for short-term loans.

As cash piles up in the Federal Reserve member banks, it leads to lower short-term interest rates. Since long-term interest rates follow short-term interest rates, Quantitative Easing leads to lower interest rates across the entire yield curve. Just as it was designed and intended to do.

By understanding how Quantitative Easing works, it is clear the process pulls cash from the large commercial banks to lock the cash in accounts at the Federal Reserve member banks. Removing cash from the economy is deflationary, which is why in an attempt to add liquidity to the financial system, the Fed causes a massive deflationary shock when it engages in Quantitative Easing.