Sterilizing QE3

I find bizarre reports that Federal Reserve policymakers are considering sterilizing a new round of bond purchases in order to “subdue worries” about potential inflation.

Here’s how the WSJ put it in the first two paragraphs of its story on March 8:

“Federal Reserve officials are considering a new type of bond buying program designed to subdue worries about future inflation if they decide to take new steps to boost the economy in the months ahead.

Under the new approach, the Fed would print new money to buy long-term mortgage or Treasury bonds but effectively tie up the money by borrowing it back for short periods at low rates. The aim of such an approach would be to relieve anxieties that money printing could fuel inflation, a fear widely expressed by critics of the Fed’s previous efforts to aid the recovery.”

The odd thing is that unintended sterilization is exactly what happened during the so-called QE1 and QE2. The Fed purchased bonds, which created an equal amount of bank reserves and deposits (money). Normally, because of fractional reserve banking, this would lead to a further multiple expansion of bank deposits and the money supply. That mostly didn’t happen because the banks held onto the excess reserves created rather than lend or invest them. Multiple money expansion did not happen and expectations of accelerating inflation were not met.

Banks now get a 25 basis point interest rate return on their reserve deposits with Federal Reserve Banks, including their excess reserves. So, in effect, the Fed has already been borrowing them. Those reserves are assets to the owning banks but are liabilities of the owing Fed. In other words, these reserves created by QE1 and QE2 have already been largely sterilized by the Fed borrowing them back at low rates. This is why the Fed’s operations haven’t been as effective as hoped in stimulating the economy nor as inflationary as the critics feared.

In addition to the unintended sterilization of bond purchases under QE1 and QE2, the more recent “operation twist” is on its face a sterilization effort—that is purchases of longer dated debt is matched by sales of shorter dated debt. That doesn’t just sterilize new reserves; it avoids creating new reserves.

By the way, I believe the word “sterilization” got the meaning we are using for it in this context in foreign exchange intervention. If a central bank buys foreign currency to hold down the exchange rate of the domestic currency, it creates more domestic money. Central bank net purchases of any asset, or services for that matter, tend to create money. If more money creation is considered not desirable then the purchases of foreign exchange are matched by sales of some other asset, usually bonds, hence offsetting or “sterilizing” the purchases.

The WSJ report said that the Fed hoped to “subdue worries” about future inflation, not prevent future inflation. In other words, it would sterilize in some different way just to give a greater appearance of sterilization. I know it must be frustrating for the Fed to have it’s critics continue to charge that it is stoking inflation while inflation falls instead, but I would think Mr. Bernanke could find a way to explain the sterilization that is already taking place and not have to create a new program simply for the optics that has the same effect.

The WSJ article did not quote any sources by name, but the tone implied that the author got his information from some Fed policymaker. I’m surprised and disappointed that such a conversation took place and also disappointed that Fed policymakers seem to be actively planning a new round of quantitative easing. While it’s important that they keep the balance sheet growing slowly to provide for continued modest money growth, that can be done without a new Q program. What they should be focused on, in my opinion, is how to allow interest rates to rise a bit in the context of a generally accommodative policy. Interest rates have already been too low for too long in my opinion and the end of 2014 is a long time more.

 

 

Comments (2)

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  1. Andy Harbison says:

    The thing that seems a tad “bizarre” to me is that the QE1/QE2 sterilization could be considered “unintended.” Dr. Bernanke could at any second say, “I know let’s what, let’s NOT pay 25 basis points on that 1.6 TRILLION!! in excess bank reserves.” The good doctor is paying because that’s what it costs to keep those worms in that can. He’d pay 50 in a heartbeat. Or 100. There’s the problem, he has short term risk. At 25 BP he prints 4 billion a day and he doesn’t want it going to 16 billion completely unanticipated. The new “twist” let’s him lock in a rate at least for a bit when he does QE3. The reason he’ll do QE3 is because he thinks it’s needed to prop up this house of cards a little longer.

  2. Joe Barnett says:

    “Interest rates have already been too low for too long.” Absolutely. It is unfortunate that the Fed is expected to — and is trying — to do the job that fiscal and tax policy have to do. If monetary policy could get the US & world economy out of the doldrums, it would already have done so.