First, envision part of the QE process. The Fed purchases a security — a US Treasury, or a slice of MBS — from an investor. That investor then sends the ensuing proceeds to a bank — generating an extra deposit. The bank can then lend that deposit to someone else to buy another security. So the deposit eventually returns to the bank, and it can then lend 90 per cent of it out again. And so on.
In theory, for every dollar the Fed injects into the economy with its asset purchase programme, banks should be able to leverage this 10 times through the bank multiplier. In practice, though, not so much.
Banks balance sheets have traveled sideways — despite $2,000bn worth of QE.
Here’s Dominic Konstam and Alex Li from Deutsche Bank:
The $2 trillion in purchases have literally gone down a black hole. Required reserves haven’t been required to increase and the Fed reserve add has literally simply been hoarded as cash. Excess reserves at the Fed have subsequently soared by the same. In short, QE has been a spectacular disappointment in its impact on bank lending, whether via whole loans or securities. It was as if the banks conducted the very sterilization of QE that many thought perhaps the Fed should do to “contain” inflation expectations.
Risky security prices have risen since QE but not Treasuries, the main instrument of QE2. Yet banks’ balance sheets have gone sideways. Effectively investors have marked asset prices higher and circumvented the banks. It is as if the first purchase by the Fed from an investor simply triggered a series of deposit for security switches through the investor base with banks never making an additional loan. This is consistent with a greater concern for risky asset post QE2 end, than Treasuries. The danger for investors is that they confuse the result of higher asset prices as reflecting excess liquidity rather than “irrational” exuberance given that actual liquidity (as broadly defined by the banking system) hasn’t gone up at all.
Now think of the QE2, scheduled to end in fewer than two months:
For all the worries about the end of QE2, the focus should be on how we came about the “risk on” trade and elevated asset prices. It was not through revitalized bank lending. There is no banking system that is standing on its own two feet and propelling growth forward. It remains like a herd of deer in the headlights – ready to hand the cash straight back to the Fed when asked for. If risky asset prices were elevated because of the expectation of a kick start from the banks, they are at risk of falling. Treasuries are immune because no one could buy them as the Fed purchased them. There is no call on loans that funded Treasury positions through QE2. Moreover if the banks slowed the pace of deleveraging (deposit destruction) because of the safety of their cash hoard, there is a risk that they may become even more recalcitrant.
Of course, you could argue that this is exactly what the Fed’s been planning.
You sideline a broken banking system and then rely on bond and stock markets for your recovery. But it’s a plan that itself is dependent on those markets keeping up an irrational exuberance without permanent help from the central bank. Either that, it seems, or banks magically start lending…
Dick Bove on QE2 as a bank-less “financial war with China” – FT Alphaville
Pricing risk redux (irrational exuberance – the sequel) – FT Alphaville
Moving targets, QE edition – FT Alphaville