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Macrovoices Notes

The purpose of Quantitative Easing is to strengthen the dollar and lower Treasury yields by purchasing large quantities of government debt and trapping dollars in the financial system. Without lending growth, Quantitative Easing is disinflationary and potentially deflationary, until lending growth is large enough to overcome the negative effects of Quantitative Easing.

It is the creation of new money through lending growth that drives inflation, which is why the Federal Reserve seeks to lower interest rates and strengthen the dollar to entice American consumers to borrow and spend.

Quantitative Easing is a reserve swap where a commercial bank sells a bank reserve to the Fed in exchange for a Reserve Asset. Commercial bank reserves are created by customer deposits, which the bank uses to purchase Treasury securities. Since most money deposited in a commercial bank stays there for several years or more, the dividends from short-term Treasury securities are used to pay interest to depositors.

The U.S. Treasury issues debt, some of which is purchased by primary-dealer banks. The primary-dealer banks sell some of their inventory to the commercial banks who pay for them with customer deposits to create bank reserves. The Fed purchases $80 billion a month of bank reserves and the commercial banks receive a Reserve Asset in exchange.

By removing $80 billion per month of Treasury securities from the market, the Fed seeks to lower Treasury yields. The Fed further lowers Treasury yields by reducing the duration, or time to maturity, of a commercial bank’s reserves.

Reserve Assets created by the Fed have an overnight duration, whereas banks create bank reserves from customer deposits with Treasury Bills and Notes, with maturities ranging from four weeks to seven years. By reducing the average duration of a commercial bank’s reserves from three-to-five years to an overnight reserve, interest rates can fall.

The reason Quantitative Easing leads to a stronger dollar is it locks up cash, or customer deposits, inside the commercial banking system. Reserve Assets created by the Fed are held at Federal Reserve member banks and can only be sold by the Fed through Quantitative Tightening. As a result, cash gets tied up in the commercial banking system and its mobility is limited between the large commercial banks that can settle accounts between each other with Reserve Assets.

By locking cash inside the commercial banking system, the velocity of money, or how many times money is used in a transaction during a given period, significantly declines due to Quantitative Easing. Even though the Fed lacks the power to destroy dollars, it can lock dollars up inside the commercial banking system in hopes those dollars outside the commercial banking system will be scarce and become more valuable.

Many people believe that Quantitative Easing increases the money supply, it is not true. Since Quantitative Easing needs bank deposits to be converted into bank reserves to be swapped for Reserve Assets, ongoing Quantitative Easing requires the money supply to grow. Fiscal stimulus is important in the continuation of Quantitative Easing, as borrowing dollars from foreign sources and giving them to American taxpayers leads to some of the money being deposited at the commercial banks.

The notion that inflation is created by combining Quantitative Easing with fiscal stimulus is an inaccurate assumption. While it is possible to create inflation in the short term with a large fiscal stimulus injection, due to Quantitative Easing’s demand for bank reserves, its inflationary effects are transitory. As dollars from fiscal stimulus make their way into the commercial banking system, Quantitative Easing will significantly reduce their velocity which leads to further disinflationary or deflationary pressures.

The reason Quantitative Easing leads to disinflation and potentially deflation if left running too long is it creates a liquidity trap. A liquidity trap occurs when the demand for money, from Quantitative Easing, increases more than proportionally to the money supply. When the demand for money increases more proportionally than the money supply, aggregate prices must fall to close the gap.

A liquidity trap is nothing more than a dollar shortage brought on by a central bank engaging in large-scale asset purchases, or Quantitative Easing, for an extended period which traps money inside the commercial banking system. The longer Quantitative Easing is allowed to run, the more severe the dollar shortage gets without any lending growth.

Lending growth, when looking at all loans and leases at commercial banks, is at zero percent on a year-over-year rate. There is no lending growth, which means money supply growth will be heavily dependant on fiscal stimulus. Due to the negative impact of Quantitative Easing, without lending growth, further disinflation or deflation will be prevalent due to dollars being trapped inside the commercial banking system.

To get out of the liquidity trap, interest rates will need to substantially fall to generate lending growth, which I predict rates will need to be near zero percent across the curve, asset prices will crash, or both. Prior liquidity traps have been resolved with Treasury yields falling to new all-time lows, which would put most of the yield curve near zero percent. The larger the liquidity trap grows, the lower Treasury yields will need to go to close it barring an outright financial crisis.