The Meaning(lessness) of Money — Why “Quantitative Easing” Won’t Do What People Think it Will Do
There has been much talk, of late, about the ineffectiveness of conventional monetary policy — i.e., lowering the target for the overnight interest rate to incite borrowing and hence economic expansion — and the need for monetary authorities to consider something more dramatic, like so-called “quantitativeÂ easing” — the active buying of government debt and other securities in the open market ostensibly to “increase the supply of money” in the economy with a goal of (a) greasing the wheels of finance; and (b) creating inflation expectations.
Trouble is that quantitative easing is more or less meaningless in a modern monetary economy (its major price impact is meaningful however and is discussed below).Â Â As I suggested in a previous post, banks are not constrained by the supply of government money in their lending activity since the Bank of Canada always stands ready to accommodate the growth in privately-created credit money.Â If it didn’t, the Bank of Canada would be unable to hit its target for the overnight rate which remains, even in today’s crisis, the main monetary policy tool.
Let’s walk through an example.Â Suppose the Bank of Canada is targeting a 0.5% overnight interest rate.Â Suppose further that for whatever reason, the Bank decides to engage in “quantitative easing” and goes out and buys $1 billion worth of government treasuries on the open market.Â What happens?
1.Â The banking system as a whole is suddenly in a surplus position on the Large Value Transfer System (LVTS), which is where large overnight transactions are settled;
2. Individual banks with a negative LVTS balance will find more than enough positive balances (held by other banks) to settle their overnight obligations.
3. The overnight rate will drift well below the Bank of Canada’s target.
4. Seeing this, and wanting to maintain it’s target at 0.5%, the Bank of Canada will have to transfer $1 billion of government deposits from the private banks onto its books to neutralize its initial purchase (or use Sale and Repurchase Agreements -SRAs).Â In other words, the Bank will do what it normally does and target a zero balance (actually a small surplus) in the LVTS.
So if open market operations must be neutralized to hit an overnight target, why would the Bank of Canada even bother to make these purchases?Â Two reasons, neither of which have anything to do with “the money multiplier” or the “quantity theory of money.”
First, the Bank of Canada may want to “make a market” in a given asset class, i.e., assure some liquidity to a seized-up marketÂ (ABCP anyone?).Â Second, it may want to signal a desired direction for bond prices and yields — by bidding on (say) government of Canada debt, the Bank increases demand to that debt/asset class and effectively drives up prices and yields down.
Is any of this inflationary?Â Again, certainly not through any money multiplier relationship or quantity theory relationship but only through the normal, indirect method of dropping the cost of credit (yields) and thereby increasing the incentives to borrow.Â But that’s what the Bank of Canada always does — it is a self-confessed “quantity taker” and “price setter.”
And what happens if the BoC purchases debt when it’s overnight target is zero percent (coming soon to an economy near you)?Â Not much.Â The bank system will simply have a perpetualÂ LVTS surplus and overnight bids will drift towards the Bank’s new target of, yes, zero.Â Will this compel the banks to lend more money?Â Maybe, but only if they think that their borrowers are going to be able to repay them, i.e., are creditworthy.Â And that’s no different than at any other time.
There’s no magic here. Just a lot of misunderstanding in the popular press and among far too many economists — and even central bankers — who ought to know better.