Analyst Insight
Understanding what the Fed has done as it relates to quantitative easing
In the wake of the pandemic, the Federal Reserve (The U.S. version of the Bank of Jamaica), supported the US economy through quantitative easing (buying government bonds by printing money – note that money printing in this article means money creation because the Federal Reserve does not print the physical cash) and all-time low interest rates (0% to 0.25%). Ultimately, these measures significantly aided the economic recovery as they provided liquidity to the economy and lowered the cost of borrowing which, in turn, induced spending. A major consequence of this easy monetary policy has been elevated financial markets and we’ve seen this directly as US stock exchanges have climbed to record highs. Now, since the world has been reopening and demand has catapulted, supply has largely struggled to keep pace. This has been a major factor that has propelled heightened global inflation that has become increasingly lasting, notably in contrast to the early expectations of the Federal Reserve (“The Fed”) and many other central banks globally. Given this turn of events, the Fed, at a quickening pace, is slowing its quantitative easing (slowing its money printing) and is expected to pull forward its decision to increase interest rates from their historically low levels. Essentially, this would reduce and eventually discontinue the quantitative easing (“QE”) and overall easy monetary policy that was used to combat the negative economic effects of the pandemic. In this article, however, we will demonstrate that contrary to popular expectations, the effects of quantitative easing may not end when the Fed stops printing money but should, in fact, continue for some time. This could therefore keep asset prices elevated.
Understanding the Treasury
Let’s get more granular with quantitative easing… An important point of departure is that when the Fed decides to print money through quantitative easing, that money ultimately goes to the Treasury’s general account (The Treasury is the US version of the Ministry of Finance). The general account of the Treasury can be thought of as the wallet of the US government. However, in order for money from the Treasury to enter the actual economy, i.e., to everyday citizens, the Treasury must make payments through commercial banks. Side note… at the height of the pandemic, the Treasury was borrowing from the Fed (the money printer) to give money to Americans. However, two things must be remembered: (1) The Treasury always has a mandated limit on its borrowing, and (2) The Treasury breached its borrowing limit to pay Americans, so much so that some of the money borrowed was not actually used. The Treasury was able to breach this limit because a suspension was placed on the limit but once that suspension expired, the Treasury had to stop borrowing and repay much of what was borrowed to get within its limit. Since then, the limit has been suspended again and is expected to be increased eventually (no definitive date has yet been set) which would make it possible for the Treasury to increase its borrowing.
The combination of the Fed and the Treasury’s actions
Now, if you’ve been following, you know that The Treasury had to repay significant sums of money to reduce its debt before its debt limit suspension date. By law, the Treasury cannot hold more debt than is mandated unless there’s a suspension of the debt limit and once that suspension expires, the Treasury must have less debt than the debt limit. With that in mind, since the Treasury repaid so much money, where did it go? It went to money market funds, the second-largest buyer of the US government’s debt, after the Fed. Now, the law of supply and demand says that higher supply generally results in lower prices, so as the Treasury repaid huge amounts of money to money market funds, the price (in this case it’s a rate) on the Treasury’s bills (Treasury’s debt) became extremely low as there was an abundance (too much supply) of money. It was so low that it threatened to push the Fed’s 0% to 0.25% rate mentioned early, into negative territory. Certainly, the Fed could not allow this to happen so it utilized the reverse repo facility typically called RRP. The aim of the RRP was, in large part, to give money market funds somewhere to place their money at a definitive rate of 0.5% so rates would not go negative and it has worked very well. It has worked so well that the RRP now has US$1.5 trillion, coming from as low as US$0.00 in March 2021! But of course, the RRP is money still held at the Fed which means it is NOT in the real economy! We believe that this money will eventually make its way into the economy so while QE may stop, the effects of QE may persist as money already printed (currently in the RRP) flows into the system.
Concluding Thoughts and Implications
Eventually, the Treasury’s debt limit will need to be increased so they can borrow more money (the U.S. debt is continuously on an uptrend). Once this happens, they will resume borrowing but this time the Fed will not be the major lender (no money printing/no QE). This means money market funds, in large part, will be lending to the Treasury. So, where will they get the money? Well, they have approximately US$1.5 trillion of money in the RRP and will likely lend it to the Treasury. Why lend the Treasury now when it was almost yielding a negative rate before the RRP? As the government borrows more, it pulls money out of the RRP, reduces the supply of money, and thereby increases the rate on money and makes lending the Treasury more attractive. The Treasury will then spend this borrowed money into the economy through commercial banks. That means money moves from the RRP and into the financial system through commercial banks as deposits. As the system gets more deposits and matches these deposits with low-rate assets, banks will eventually seek higher earning assets with this new money (this is how banks generally earn). That means, we could see asset prices go higher or remain elevated, contrary to what would be expected since the Fed is reducing its easy money policy, as stated at the start.
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Written by Awah Muirhead
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