Thread by @MacroAlf

Yesterday I asked people on FinTwit to ask questions about how QE works and what are its consequences on the economy and asset prices, and I promised to answer to the 10 most interesting questions.

Here we are: the questions were awesome, buckle up!

0/10

Q: ''Why does the following QE process NOT create money? An asset manager sells a gov bond to the CB & receives a bank deposit, which it can use to buy a new bond from the gov, which in turn can spend the proceeds of that new bond sale into the real economy''

A: in this example, the only creator of inflationary forms of money is the government that prints additional deficits; the Central Bank simply swapped the gov bond for a bank deposit on the asset manager balance sheet.

1/10

Q: ''When the FED buys from non-banks, increasing the deposits, where did that money come from? How isn’t that inflationary?''

A: Asset managers, pension funds and other non-banks will have their B/S asset side composition forcefully changed into more bank deposits and less bonds. They can't do anything ''CPI inflationary'' with those bank deposits. They can only replace those with other assets.

2/10

Q: ''QE is not money printing but an asset swap. Then where is the underlying monetary base behind these crazy IPOs, cryptos, nfts...?''

If you swap trn of the asset side of the private sector from bonds to 0 duration, 0 yield assets (reserves/bank deposits from non-banks) you encourage risk taking. Couple that with large fiscal stimulus (the real money printing) and negative real rates on risk-free assets.

3/10

Q: ''Why did QE lead to asset price inflation in the US (correlation or causation debate aside) but not in Japan where they've been doing it for far longer?''

A: Because the BoJ decided to kill the party causing an abrupt increase in real interest rates and the private sector went on a strike for decades to follow: continuous deleveraging more than offsetting any attempt from the govt to print fiscal deficits and BoJ's QE.

4/10

Q: ''Why does the Fed pay interest on reserves if it wants lending?''

A: It's just a monetary policy decision, mostly to avoid de-anchoring of front-end yields vs what the Fed wants to see. Banks don't lend reserves in the first place but create money out of thin air when they extend loans, so the IOER is irrelevant there.

5/10

Q: ''Is QE essentially the same in USA, EU and UK? Are there any big differences in the way CB deposits can be used by commercial banks in these countries?''

A: It's essentially the same. There are some small technical differences, but they most relate to how/what HQLA regulation allows these reserves to be recycled - it's mostly government bonds and low risk assets anyway.

6/10

Q: ''Does QE have any impact on banks' interest in lending?''

A: Not directly, zero correlation. Banks increase lending activity if the trade off between loan yields, capital requirements and borrowers' creditworthiness is good. They are capital constrained, not reserves constrained - you can have a gazillion $ Fed balance sheet, same

7/10

Q: ''Given the Fed was already expanding QE in 2019; how much more sensitive are assets at 8T vs 4T ?''

A: The amount of bank reserves in the system matters. If you flooded the pvt sector with reserves, there is a marginally higher chance they will be willing to allocate a portion of those to credit products if spreads widen. That also limits drawdowns in other risk assets.

8/10

Q: ''What about long-term implications of QE? IMO it does affect the mechanics of relative prices.''

A: Yes, it does. The portfolio rebalancing effect is real, but it's not fully mechanic. Regulation plays a big role when it comes to relative asset prices valuations: a bank treasury won't buy HY bonds if the spread is not good enough, even if it has abundant liquidity.

9/10

Q: ''Why do long term treasury yields tend to decline when the Fed begins tapering?''

A: Because removing accommodation generally reduces the uncertainty about the future path of nominal growth - it's more likely to stay low and revert back to structural poor trends.
That means owners of long-end bonds can demand less risk premium to own this asset class.

10/10