Update: Quantitative Easing: What is the Federal Reserve Really Doing?
publication date: May 21, 2012
Update May 21, 2012: After the Federal Reserve completed its second round of quantitative easing (QE), explained in my previous article below, various pundits have speculated whether their would be a third round of QE because of further expected economic sluggishness. With the recent resurgence of problems in the EU and a slowing of U.S. economic numbers, speculation is growing that a third round of QE is coming.
A reader sent me a recent question about QE which highlights a topic I often see put forth by pundits and the media: "...you state that the Fed is not printing a ton of money. However the accompanying graph showing percent change in the money supply reveals increases of as much as 10% or more in some periods over the previous year. That seems like a lot. Doesn't this continuous expansion reduce the value of all money?"
The short answer is not really. The money supply graph below uses the M2 measure of money supply. This definition of money supply includes "...the sum of currency held by the public and transaction deposits at depository institutions...plus savings deposits, small-denomination time deposits (those issued in amounts of less than $100,000), and retail money market mutual fund shares," according to the Federal Reserve.
Retail money market assets and bank deposits, could increase for example, if individuals decide to hold more cash. Also recognize that the demand for these highly liquid assets can come from folks around the world so increased demand for the U.S. dollar during times of stress can lead to the growth of M2. Changes in money supply are complicated and perhaps the subject a future article.
During and after the 2008 financial crisis, I've written numerous articles about the Federal Reserve, Fed Chairman Ben Bernanke, and the actions the Fed has taken. I've explained their most important actions and discussed the expertise and qualifications of Chairman Bernanke. Many pundits interviewed on financial cable television programs and website pontificators have used the Federal Reserve as a punching bag, blaming them for various economic problems including the 2008 financial crisis. Despite the rebounding economy and stock market, some of the critics have gotten even more vocal of late blasting the Fed for the $600 billion "quantitative easing" program begun late in 2010.
More often than not, the most vocal critics, who typically and erroneously claim to have predicted the 2008 crisis, have an agenda to appear smarter than everyone else including the Fed. Some of these pseudo-experts are precious metals hucksters and thus like to claim that the Fed is going to cause hyperinflation which will impoverish you unless you buy gold, silver, etc.
In one popular video which has millions of YouTube views, the author claims/states the following using goofy cartoonish characters:
- The Fed is printing a ton of money to implement quantitative easing (QE).
- QE is being done to stop deflation (falling prices) but the Fed is too dumb to realize that consumer prices are rising not falling.
- The Fed has been wrong about everything the past 20 years.
- Fed Chairman Ben Bernanke is unqualified for his job because he has no business experience, no policy experience and has never held an elected office. He is a fool who's been wrong about everything during his tenure in office and has already blown up the American economy and is now working on blowing up the world economy.
- The government is stupidly buying Treasuries from Goldman Sachs at grossly inflated prices (rather than buying Treasuries from the Treasury department). Goldman Sachs makes its living ripping off the American people.
Don't Confuse Me With the Facts
While it's stunning in and of itself that this video has been watched about 4 million times in just two months, what's even more amazing and disturbing to me is how many mainstream media and other websites and outlets have promoted and recommended the video with little if any effort made to fact check and reality check its contents. I will do so now, in part, to set the record straight and to advance your understanding of what quantitative easing really is and why the Fed is doing it. Let's go through the video's main assertions point by point:
- The Fed is not printing a ton of money to implement QE (see graph below which shows annualized changes in money supply).
- The Fed is well aware that there is inflation right now but has been concerned that the rate has been quite low by historic standards and that there were signs of accelerating deflation during the severe recession (see graph below showing the annualized changes in the consumer price index).
- If the Fed had been wrong about everything the past 20 years and had never been right, our economy would be in a shambles and our stock market would not have appreciated more than 500 percent over that period. Yes, the U.S. has a high unemployment rate now but my regular readers know from my prior articles on unemployment that it is due to various factors, notably current tax policy.
- Bernanke is well qualified for his job, a topic which I covered in March, 2009, during the depths of the stock market slide and recession.
- The Fed is buying Treasuries from banks at competitive prices and is doing so to encourage more bank lending (please see section below for more detail on QE and how it works). It is absurd and a lie to suggest that the Fed is directing this buying solely to Goldman Sachs. The Fed conducts such Treasury open market operations through an approved list of 18 primary dealers of which Goldman is one of the 18 dealers operating in a highly competitive environment. Goldman bashing has been going on for a long time and I addressed this in a previous article.
Quantitative Easing (QE) Explained
In various speeches and selected interviews, Fed Chairman Bernanke has explained QE. Here's one fairly plain English explanation (note: "central bank" means the Federal Reserve) that Bernanke made during the height of the credit crisis:
"Quantitative easing can be thought of as an expansion of the central bank's balance sheet with no intentional change in its composition. That is, the central bank undertakes more open market operations with the objective of expanding bank reserve balances, which the banking system should then use to make new loans and buy additional securities. However, when credit spreads are very wide, as they are at present, and the credit markets are quite dysfunctional, it becomes less likely that new loans and additional securities purchases will result from increasing bank reserve balances.
In contrast, credit easing focuses on the mix of loans and securities that the central bank holds as assets on its balance sheet as a means to reduce credit spreads and improve the functioning of private credit markets. The ultimate objective is improvement in the credit conditions faced by households and businesses. In this respect, the Federal Reserve has focused on improving functioning in the credit markets that are severely disrupted and that are key sources of funding for financial firms, nonfinancial firms, and households."
In addition to explaining QE in this speech, Bernanke also delineated that in order for QE to work, the credit markets must be healthy as they are now but weren't in late 2008 and into 2009.