You Need To Know Why QE Did NOT, And Does NOT Work

March 26, 2021

You Need To Know Why QE Did NOT, And Does NOT Work

Apocryphal Einstein Quote The definition of insanity is doing the same thing over and over again, and expecting different results

First, we need to define what is meant by QE “didn’t work”.

QE as a policy is meant to generate inflation in the economy by printing money. On the surface, this sounds simple enough, after all everyone has a pretty good notion of what “printing money” means.

Unfortunately, the only simple part of that two word phrase is the word “printing”.

It turns out that Money, in this modern age, is not that easy to define.

Putting it very simply, money is anything that anyone accepts as payment for goods or services. Conversely, it follows that if not enough people accept something as payment, then it cannot be considered to be money.

Hold this thought while we dive a little deeper into the mechanics of the Fed’s QE programs.

In every iteration of QE, the Fed pays for the assets it purchases in bank reserves. Recall that bank reserves are not money.

However, the Fed thinks it is (they have yet to indicate otherwise).

Trillions of USDs worth of reserves have been pumped into the financial system as a result, simultaneously withdrawing the same notional amount of US Treasuries, mortgage backed securities, etc.

Hence, QE is nothing more than an asset swap, since banks are transferring fixed income instruments from the asset side of their balance sheet in exchange for reserves, which also sit on the asset side.

Nothing is created in the financial system in such a transaction – it’s pretty much the equivalent of moving stuff from one’s right pocket to their left one.

The reason the Fed continues these asset swaps is seemingly because of the incorrect mainstream belief that new money is created in the economy by banks loaning out bank reserves.

Banks do not loan out bank reserves, instead, banks create money in the economy ex nihilo .

Now, remember that these fixed income instruments, especially US Treasuries, are what the financial system uses as money. Given this new understanding, is it that surprising a decade of QE has not generated inflation meaningful enough for the Fed to hit its 2% target?

Chart showing how PCE continues to trend down even as bank reserves explode higher

Using the Fed’s preferred inflation indicator, the PCE index (Personal Consumption Expenditure Chain Type Price Index), we can see that inflation has never really consistently come in above the target level of 2%.

Instead, after a promising sustained move higher post ‘08 and into mid 2012, the PCE has only been above 2% for two short stretches, in 2017 and 2018.

Even as bank reserves continue their upward trajectory with the Fed’s endless QE, inflation as measured by the PCE is stuck in a downtrend that began pre-2008.

Clearly ever more bank reserves are not the answer to the US economy’s problems, which begs the question: How can there be meaningful inflation as long as global central banks cling to QE as their savior?

Note: If “money”, what constitutes “money”, and how it is used and moved around the economy and financial system is a topic that interests you, it is well worth doing extensive further research. It will not take long before you realize that money is a much more intangible concept than the vast majority of people think it to be.