Learning by doing – the next phase for monetary policy – reversing QE

October 13th, 2017 by Brian Kantor

The success of Quantitative Easing (QE) in promoting a global economic recovery calls for its reversal and the resumption of more normal in monetary affairs. The scale of QE, that is the creation of cash by central banks since 2008, has been extraordinary and unprecedented. Why this injection of cash has not led to more spending, much more inflation and a much greater expansion of the banking systems and in bank deposits than has occurred has been the big surprise. Providing an explanation for these highly muted reactions can explain why the reversal of QE may also be less eventful than might ordinarily be predicted.

The total assets of the major central banks, US, Europe and Japan grew from just over 3 trillion dollars in 2007 to their current levels of over 13 trillion USD, an amount that is still increasing The Fed balance sheet grew from less than one trillion dollars in 2008 to over 4 trillion by 2014.

The key fact to recognize is that almost all of the trillions of cash created by the Fed and other central banks buying the bonds and other securities that so bulked up their balance sheets, came back in the form of extra bank deposits. Commercial member banks before 2008 held minimal cash reserves in excess of what regulations said that were required to hold. They exploded thereafter. These excess reserves in the US peaked at 2.5 trillion dollars in 2014 remain above 2 trillion dollars worth of potential lending power.

The banks holding cash rather than making loans or buying assets has not only led to less spending than might have been predicted, it has also led to a much slower growth in bank deposits. It has shrunk the dramatically the ratio of total US bank deposits to the cash base of the system. This money multiplier has declined from nine times in 2008 to the current 3.5 times. Therefore the size of the banking system relative to the GDP has declined and made the US economy less dependent on bank credit. The US commercial banks on September 27th cash assets were equal to an extraordinary 20% of their deposit liabilities.

Extra bank lending requires that banks attract not only extra cash but also extra capital. Banks were undercapitalized before 2007 and have had to add to their capital to loan ratios. This has restrained bank lending as has a reluctance of potential clients to borrow more. Holding extra cash rather than making additional loans was an understandable choice. The extra cash held by US banks also earns interest, a further incentive to hoarding rather than lending cash. Low inflation – more so deflation – falling prices – can make holding deposits with the Fed, a good investment decision. The Fed minutes released yesterday reveal a concern that currently very low inflation may be “more than transitory”

Coming reductions in the supply of cash to the banking system are very likely to be offset by reductions in the excess cash reserves banks hold. Given the volume of excess cash reserves held by banks the danger is still of too much rather than too little bank lending to come. Were excess cash reserves to be exchanged on a significantly larger scale for bank loans the FED would have to accelerate its bond sales and raise interest rates at a faster pace.

This would all be a sign of faster growth and welcome for it. But there is possibility of a slip twixt central bank cup and lip and that markets will misinterpret the signals coming from central banks. So adding volatility and risks to markets before or as a new normal is established. Past performance will not be a guide to what will be another  unique event in monetary history- first was QE- then its reversal.

  • Ilan Strauss

    Very useful, and clearly written, article.