Thursday, 31 October 2013

Why the Fed can't taper

John Aziz has a post explaining why the Austrian school of economics is wrong to believe that the Fed can't taper because of the risk of asset collapse and hyperinflation.

I actually have some sympathy for the Austrian argument that the Fed cannot taper, but not for their reasons. They wrongly focus on base money creation as the main problem. But as Aziz says, base money creation would have to be a) far more extensive and b) have a far more direct effect on broad money to result in the hyperinflation that they fear. The real risks come from the market effects of persistent QE.

Central banks have become the largest players in global markets. It is somewhat unclear as to whether markets respond to central banks or vice versa - it's probably a bit of both - but we really can't pretend that central bank actions have no effect on global markets. The Fed is the largest and most important central bank in the world. Its actions are critical to the operation of global markets. Prices along the yield curve are governed by market view of the Fed's likely future actions - often the wrong view, because the Fed's price signals are far from clear, despite its vaunted commitment to "forward guidance": to see just how conflicted Fed price signals can be, you only have to look at Bernanke's announcement of imminent tapering followed by delay after delay. There remains a high degree of uncertainty in the markets regarding the future path of US monetary policy, which makes markets unstable and over-reactive. It's as if everyone is in a state of "amber alert" - there is a hurricane coming, but we don't know exactly when or where it will hit or how bad the damage will be.

Exactly how QE affects the economy is a matter of considerable debate. Inflation expectations tend to rise when QE commences, because many investors still think expansion of base money = inflation. But there appears to have been little or no effect on consumer prices, and it is unclear to what extent asset purchases benefit the wider economy. However, the one thing we KNOW QE does is support asset prices - all classes of asset, not just government bonds and MBS.  Global markets have become used to this support: investment decisions are now governed to a large extent by the desire either to avoid capital erosion on safe assets (hence moves into assets that give zero yield, such as cash - zero yield is better than negative yield) or find some positive yield somewhere.

Tapering is removing central bank support of asset prices. Unless not just the US economy but the GLOBAL economy is "on the up" at the time that tapering commences, the result of tapering will be a global fall in asset prices. That isn't going to cause hyperinflation, as the Austrian school thinks, but it would cause a global recession.

I'm afraid it is not US fundamentals, but global fundamentals that will determine the Fed's ability to taper. If the Fed tapers when the global economy is already in the doldrums, as it is at the moment, the recessionary rebound to the US economy would be considerable.

It would also in my view be highly irresponsible of the Fed to cause a global recession by ill-judged tapering. Because of the US dollar's pre-eminence (and the pre-eminence of USTs, too - we don't talk about that enough), the Fed is effectively the world's central bank. It is high time that the US accepted that its monetary (and fiscal) policies must be driven by the needs of the global economy, not just the US. The "exorbitant privilege" is an exorbitant responsibility, too.

Related reading:

Can the Fed taper? - Azizonomics
World Economic Outlook, October 2013 - IMF
The Ins and Outs of LSAPS - Krishnamurthy & Vissing-Jorgenson
Methods of Policy Accommodation at the Interest Rate Lower Bound - Woodford

50 comments:

  1. The monetary base expansion isnt doing anything as it has no velocity in the hands of the banks. If you put that same money in the hands of the the overall public velocity would increase significantly as a result of a much higher MPC. All the CB's need to do is adopt a wider and more balanced set of counterparties instead of myopically focusing on banks and asset holders. Asset holdings are too concentrated making MP too ineffective.

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    2. Asset's are what the Central bank is buying so there must be an asset to buy and its not obvious what asset the overall public have for the central bank to buy. Also the overall public are not market participants with an influence on interest rates. QE is aimed at lowering interest rates by purchasing assets such as government bonds thus replacing them with cash, with the intention that the investor looks for another asset, or bond and hence influencing borrowing costs downwards.

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    3. There is no need for the CB to buy assets in exchange for the asset it creates (money). The central bank can simply monitor the economy and create money at a rate necessary to achieve its inflation and other targets.

      If the CB doesnt take assets off the market when it creates money it wont affect the amount of safe assets in the market place or reduce available collateral or interfere with asset markets in general.

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    4. "QE is aimed at lowering interest rates by purchasing assets such as government bonds thus replacing them with cash, with the intention that the investor looks for another asset, or bond and hence influencing borrowing costs downwards."

      QE aims to lower rates in order to increase lending and also increase spending through the wealth effect experienced by asset holders. Expanding money directly into accounts of public is more effective because it will increase the net wealth of all people increasing access to credit. Also people with a higher MPC will experience the wealth effect and spend more which will increase employment which is key in accessing credit.

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    5. You are suggesting that the CB give people money. That is a radical idea outside the realms of economic transactions , and what the CB bank does. Also when an asset is purchased it can later be sold. The CB is not expecting to loose any money or distribute any money in QE. The Bank of England website on QE does not mention a wealth effect. The point of reducing borrowing costs is that it enables money to be spent on a similar amount of extra productivity.


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    6. Appropriating money to people through monetary policy is radical becuase it would be an unprecedented step forward in MP efficiency. Its better than banks appropriating it to people when they deem them worthy of a loan in order to profit. So long as the CB creates money with reference to its inflation and other targets increased efficiency should prevail.

      "The CB is not expecting to loose any money or distribute any money in QE."

      Look at historical money supply it always grows through MP.

      "The Bank of England website on QE does not mention a wealth effect."

      The following link from the BOE mentions the wealth effect:

      http://www.bankofengland.co.uk/monetarypolicy/Documents/pdf/qe-pamphlet.pdf

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    7. I read the pamphlet and is does in fact contain the phrase ". That will push
      up the prices of those assets, making the people who own them, either
      directly or through their pension funds, better off. So they may go out and
      spend more"

      I was suprised to see that but there it is. Also it is slightly at odds with the statement in
      http://www.bankofengland.co.uk/monetarypolicy/pages/qe/default.aspx
      "Furthermore, the asset purchase programme is not about giving money to banks. "



      But you still have the problem of a lack of assets to reverse the process.
      Central Bank activity always involves the creation of an asset and a liabilaty.

      The focus is still on putting money where it may go on to be invested or lent rather than spent solely on consumption.

      for example

      with central bank lending reserves at interest rates near zero, anyone with a mortgage can do their own Quantitative Easing.

      Money is borrowed from a second bank ,at lower rates, to pay off the bank where the mortgage is currently held, and then the second bank goes to CB for the reserves.

      Leaving the first bank with QE money.

      And voila it is done.

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    8. Dinero,

      There is no shortage of assets to reverse the process. The central bank can sell or repo the assets it holds on its balance sheet as a result of earlier purchases.

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    9. But then there is no asset to reverse the earlier purchase.

      Anyway there is no unit of money that doesn't have a corresponding asset to give it value .

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    10. I don't think you understand. Selling the asset reverses the earlier purchase.

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    11. "But then there is no asset to reverse the earlier purchase"

      There is no need to reverse a purchase or contract money if money is sent to broad economy at measured pace. The money responds predictably without too much of a lag. Its not like sending money to reserve accounts at fed and then boom at some point banks suddenly get a herd instinct and start pushing out a glut of lending and the fed has to reverse purchases of assets. All the people receiving small regular amounts of money into their accounts will have a high MPC and it will start to effect economy quickly no glut of money will build up.

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    12. The injections of money are not permanent, the money slowly returns to the Central Bank via the assets on its balance sheet.


      Good Morning Frances - I heard you on Radio 4 this morning

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    13. Good morning Dinero! Glad you were listening.

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    14. And on Newsnight in July , shall I post a link so other commentators can see

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    15. Dinero,

      You suggest that “giving people money” is “radical”. Nonsense: Keynes suggested simply printing money and spending or giving it away 80 years ago. Plus Positive Money and MMTers today advocate the idea today.

      As to “lack of assets to reverse the process” that’s nonsense as well: government can easily reverse the process by simply grabbing money off the private sector: it’s called “tax”.

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    16. The point is in the financial system all money has a productive asset giving it its value.

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    17. > Frances

      Shall I post the Youtube link -- no need to be modest !

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    18. Post if you like, Dinero.

      I've just been on Newsnight again!

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    19. Frances Coppola on Newnight July

      https://www.youtube.com/watch?v=yhMEtyeVBvc

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    20. >Frances

      Yes I saw that - which is a unusual coinidence as I hardly ever watch Newsnight !

      I think there is an argument for many small banks as it means there is a multitude of "bank managers" with jobs and reputations on the line monitoring a multitude of individual , balance sheets.

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    21. Historical evidence doesn't support that argument, Dinero. The fact is that small banks fail far more often than large banks do - as I said in the programme, a large bank failing is an extremely rare event. A lot of small banks all failing at once can cause a systemic crisis - as happened in the UK in 1974: the Bank of England bailed out 60 small lenders, including the (then) National Bank and Westminster Bank. And size is not necessarily an indicator of systemic importance, either. Which is more systemically-important - a small bank that is issuing bonds to fund international commercial lending, or a large bank that is taking deposits to fund domestic residential mortgage lending? There's the question of market concentration, too. Johnson Mathey Bank was tiny, but the Bank of England bailed it out because of its importance in the London gold market.

      The country that has experienced the most problems with financial stability, and in which there remains a widespread fear of bank runs, is the United States - which is the country that until recently had no large universal banks and thousands of little banks with individual managers, just as you suggest. And it is the country where the crisis originated, of course. Over the border in Canada, they have fewer, larger banks and a tradition of universal banking. They also have the most stable financial system in the world and were largely untouched by the financial crisis. I know which I prefer.

      I'm not arguing for insane expansion of banks such as we saw in the run-up to the financial crisis. But banking, particularly retail banking, operates on paper-thin margins. Market share matters - and that means size. Small banks fail not because they are badly run but because they have relatively high costs in a low-margin business, and because simple bad luck can cause bankruptcy in banking - it's a risky business by definition. Believe me, larger banks are safer banks - they can absorb shocks far better than small ones. One large bank failing in 100 years really is not sufficient to justify damning the entire breed.

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    22. -Back to that comment about appropriating money to people. - What the commentator is "proposing" is what the government allready does when it borrows in order to give tax cuts, or borrows instead of raising taxes in the present, they have been doing it for decades, its getting the balance right that is tricky.

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    23. > Frances

      I follow what you are saying there about small and large banks, but I wonder what the role of commercial banks is when in theory everyone could have an account at the Central Bank. I concluded that it was to control inflation, spread risk, to make bank managers accountable to depositors and share holders and thus utilise the scrutiny of depositors and shareholders, employ competition, and provide the manpower to scrutinise all those loan applications.

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    24. As it stands, everyone CAN'T have an account at the Central Bank. Even deposits where the depositors wish to take no risk are in commercial banks, not the Central Bank. And depositors do not scrutinise banks. They expect to be bailed out, so they aren't interested. The "moral hazard" of deposit insurance exists on the depositor side as well as the bank side.

      Banks don't control inflation. That's the job of the Central Bank. And I disagree that banks are there to spread risk. Spreading risk is incredibly dangerous if it means that the spreaders of risk have no skin in the game. That's what went wrong in mortgage origination and securitisation. Banks are there to manage risk, not "spread" it.

      I think it is unreasonable to expect banks to promote competition. They are commercial businesses, and commercial businesses actually don't like competition - it's not in their interests. Any business would really like to be a monopoly. Banks are no exception.

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  2. Do you have any idea why the volcoity of M2 and M1 has constantly been dropping since 2K or 2010

    http://research.stlouisfed.org/fred2/series/M1V
    http://research.stlouisfed.org/fred2/series/M2V

    Does that matter? Does that say something? One day it will simply not pay to add money ... that point has not been reached yet.

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    1. Hypnos,

      I would say we are looking at the slow drowning of the interbank market. QE increases M1 and M2, but it also increases bank reserves. Banks are obliged to hold the increased bank reserves one way or another, since the only way bank reserves, once created, can be reduced is by people exchanging them for physical cash or by the Fed withdrawing them (reverse QE, or perhaps reverse repo - they've discussed this already). Banks don't "lend out" reserves - reserves stay in the banking system regardless of what banks do. So the banks are awash with liquidity. They have no need to borrow reserves from each other any more. The interbank circulatory system is grinding to a halt.

      The other effect is falling lending. The more reserves there are on bank balance sheets, the less risky lending they can do. Peter Stella calls excess reserves "dead wood" - they crowd out credit:

      http://www.voxeu.org/article/exit-path-implications-collateral-chains

      America is still deleveraging, of course, but really bank lending should be better than it is. M1 & M2 velocity would improve with more lending.

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    2. "Does that matter? Does that say something? One day it will simply not pay to add money ... that point has not been reached yet."

      Right now it pays marginally to increase base, but it seems to take massive increases in some asset markets (stocks at record highs) in order to get a weak increase in demand. Therefore increased volatility of asset markets may be the outcome if the economy doesnt pick up soon enough.

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    3. Mrs. Frances. Thank you very much.

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    4. Anonymous. Indeed that happens. Thank you too.

      I try to avoid asking in general, since Mrs. Frances cannot learn a lot from a discussion with me. One shall not tell a banker how banking works, she will know better. The article by Peter Stella is an interesting one. Good read. I personally came to the conclusion, one must understand how the banking system works. I was happy about a blog written in British English.

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    5. The Reverse QE is under test already. A very nice man in Trader Portal told me ....
      Allotment Overnight Reverse Repo Facility
      Just wanted to share this.
      Have a nice weekend.

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    6. Hypnos,

      Indeed it is. For anyone who is interested, here's the link to FT Alphaville's series about it:

      http://ftalphaville.ft.com/tag/reverse-repos/

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  3. You say:

    "...it is unclear to what extent asset purchases benefit the wider economy."

    and later

    "...the result of tapering will be a global fall in asset prices. That ....... would cause a global recession."

    The latter seems to suggest that asset purchases benefit the wider economy by preventing a recession, so I'm not sure I know exactly what your position is here. Could you clarify.

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    1. Preventing recession and generating economic growth are two very different things. I accept absolutely that QE has the first effect but it is by no means clear that it has the second.

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    2. I thought a recession was generally understood as being a period of negative growth, so I wouldn't say there "very different". But I think you mean that it can prevent a decline in growth, but only up to a point. Which I'd be inclined to agree with.

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  4. Straw man time, BTW. Real Austrians don't fret about base money per se, their monetary understanding is far too refned for such cookbook economics. On the other hand, cod Austrians i.e., goldbug, survivalist types in search of a scrap of half digested doctrine in which to clothe themselves, do.

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  5. Dear Ms. Coppola:

    Many years ago I watched a very smart client reject a complex argument like the one you just made, saying "Who is that smart."

    Keynes will be remembered long after your words, PK's words, Friedman's, name your poison words are forgotten because he saw that economics was about the 80%, not about the 20% to whom you seem to be directly your comments. I would wager you cannot find anyone who actually thinks as you argue investors think. You might find people making self serving statements, like a John Taylor, but you cannot actually find a real investor of such a mindset. Carl Icahn doesn't, etc.

    There is a very simple reason the Fed cannot get out of QE. QE is how the US is now financing its deficit. If the Fed stopped, interest on the deficit would rise, the federal deficit would get worse, etc.

    All that QE does is buy time but no attempt is made to solve the problem--re-balance our trade deficit with China.

    That event has been put off now for 7 years. Someday it will happen. China's exports are a bubble, if the word has any meaning

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    1. If found some source that strengthens you argument ...
      http://georgtsapereaude.blogspot.de/2013/10/tapering-no-way.html

      Ignore the text ... On top the author just did say chart 1) rolling sum and chart 2) is about the last 3 months extrapolated. Would have to be checked if chart 2) does match reality.

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    2. Anonymous,

      Why on earth do you think I am only addressing what you term the "20%"? This post discusses whether the Fed really can taper without causing the wheels to come off the global economy. Trashing the global economy would cause distress to billions of people. Frankly that concerns me far more than whether the Fed is financing the US deficit. Look beyond your borders. There is a big world out there on which the Fed's actions have an enormous impact. US parochialism has to end.

      I don't appreciate my post being described as "poison words". Nor do I appreciate the fact that you have not seen fit to identify yourself. I welcome comments on my site, but I expect people to be polite to me and to other commenters here. Your remarks, and your failure to sign your comment, are discourteous.

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    3. Actually, I think that Anonymous just punctuated it poorly. I think he meant X's words, Y's words, "name your poison"'s words. He's using the phrase 'name your poison" to mean "anyone you like".

      Never ascribe to malice....etc.

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    4. We just saw the dollar carry trade unravel w/ the taper talk and the flow of dollar credit back toward the US. We also saw the rupee, Brazilian real and other currencies depreciate violently. The greatest beneficiaries of quantitative easing (IMO) have been- and are the overseas investors (speculators) making use of the dollar flows ... also the different countries themselves as the credit is flowing toward them and their speculative markets.

      Pain begins when flows reverse, the hot money flows.

      US markets did not seem to sweat the taper -- it was priced in -- but the currency exchanges blew up.

      The world depends on the Fed's moral hazard: actual taper and the rupee would have collapsed taking out the Indian central bank which needed high and low interest rates at the same time.

      The Austrians are partially right about base money increases, but they don't grasp credit flows in open systems: with ZIRP there is inflation but the carry trade removes it from the credit issuers toward the periphery.

      A reason why there is neither velocity nor monetary measures' increase is that there is little to invest in. How much does that marginal highway or office development return in domestic markets that are over-saturated with both? Economists don't understand, what society has considered 'assets' since the end of WWII have become liabilities. That is why finance finances itself, there is nothing else.

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    5. Anonymous,

      Your claim that “QE is how the US is now financing its deficit” is nonsense. QE consists of the central bank printing money and buying bonds. That has nothing DIRECTLY to do with the deficit.

      It’s true that ASSUMING QE has a stimulatory effect, then less stimulus needs to come from the deficit (for a given level of overall stimulus).

      Next , you claim that “interest on the deficit would rise” Hilarious. Firstly, governments don’t pay interest on deficits: they pay interest on their DEBTS. Second, the government / central bank machine in a country which issues its own currency has complete control of the rate of interest it pays on its debt. It can cut the rate any time simply by printing money and buying back debt (i.e. QE). And if that’s too inflationary, that can be countered by raised taxes.

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  6. "There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved"

    That's the Austrian view. With respect to tapering, doing so would be a 'voluntary abandonment' of support for asset prices, which would result in asset declines and recession, as you've written. The Austrians take it another step, which is to say that if tapering will cause problems now, it will also cause problems in the future when asset prices are even higher. If it's true that elevated asset prices are what stands between us and recession, and the Fed is the support for those asset prices, then there will never be a time when tapering is possible. Even if the argument is that at some point the elevated asset prices will result in more sustainable growth, that 'growth' will ultimately be just another layer on top of the inverted pyramid I constructed which still has the Fed support at the bottom. That's why Austrians think the Fed won't ever taper.

    I agree that 'the real risks come from the market effects of persistent QE,' and as you've also pointed out the global markets have become used to the support. The issue is that the higher and higher asset prices go, and the more people become dependent on those prices remaining high, the more imperative it is that support remains. That's where the trouble is because Fed will never want to cause recession and will push it off into the future by not tapering or steadily increasing stimulus. That's where hyperinflation may come in. But psychologically speaking, hyperinflation will only be a possibility once it's widely believed that the Fed won't ever taper,let alone raise rates, and is more likely to even steadily increase purchases over time.

    So it's not the taper itself that may lead to hyperinflation, but the active avoidance of tapering, followed by a realization that even more stimulus is needed, and will be needed over time because of the recession risks.

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    1. "The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."

      That's certainly a claim, but I don't see much of an argument. Minsky at least provided a sketch of the mechanism that he believed transformed steady expansion into de-leveraging via a "Minsky moment" inflection point.

      Basically, Minsky predicted financial history form about 1980 to today. You get a long, steady expansion, declining interest rates, periodic injections of liquidity to solve small crises, more and more reaching for yield leading to more and more risk-taking.

      Then comes the Naked Lunch moment, when everyone notices what's on the end of their fork, assets no longer seem as sound as they did, some assets default, investors run for the exits, Banks stop lending to other Banks, then a financial crisis, Central Bank intervention, and now here we are on the far side of the Minsky Moment, with de-leveraging in progress, and the Central Bank using QE to avoid an outright crash.

      And you know what, we found a third alternative. We didn't have to abandon growth permanently, and we didn't let the system collapse. We let some weak player go to the wall, but the main system survived.

      The Austrians are wrong. I suppose I should say "wrong so far", but I think they are just wrong.

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  7. The way the main stream media has covered QE by referring to "money printing" has confused a lot of people.

    In fact its not unlike normal open market operations except the difference is the gilt edge market makers are side stepped and purchases are made directly from the market instead.



    In fact with central bank lending reserves at interest rates near zero, anyone with a mortgage can do their own Quantitative Easing.

    Money is borrowed from a second bank ,at lower rates, to pay off the bank where the mortgage is currently held, and then the second bank goes to CB for the reserves.

    Leaving the first bank with QE money.

    And voila it is done.

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  8. We can look to the recent past for evidence. The Fed's balance sheet stopped growing between QE1 and QE2, and again between QE2 and QE3. Each time asset prices fell for a few months - then they recovered and continued on their long-term trend. Though the Fed ran Operation Twist between QE2 and QE3, which may have sustained market expectations.

    Here are some graphs on the matter that I made in May. My definition of QE periods is when the Fed balance sheet increased by 1%+ per month...
    http://www.kentwillard.com/5-ducats/2013/05/what-happens-after-qe.html

    Of course central bank actions do matter, and they really must if you are a bond trader. But markets generally, and even individuals, have become obsessed over QE. They have developed a psychological dependency on the central banks. I believe the response isn't that we must always have QE, but that the central banks must always posture that either they are doing something stimulative, or that conditions are improving. Since markets don't understand or really notice FARP - who knows.

    Personally, I think that QE has gotten impotent and the Fed needs something more effective. But if the Fed does remove QE, then a positive aspect is that markets might focus more on fundamentals.

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  9. Frances,
    do you think there is any chance that the Fed is giving conflicting signals to mkt to avoid speculation inflating unwanted bubbles? If you know with 100% certainty that tapering will not happen, then it's too easy to build some positive carry strategy (e.g. short UST/long US HY corporates or Nigerian bonds), pocket the carry, get out before the man with the beard says stop. This of course has happened for years already and is disastrous as it lets crap investments skyrocket and leaves policy hostage to the sky high valuations.
    I wonder if Mr Bernanke is just playing with the market to enforce some risk discipline, and will continue to engineer mini crashes and mini rallies until he's comfortable that he can pull the plug with after all manageable consequences. remember this is the guy that said he does not care whether one asset class goes up and down, but keeps tabs of the direction of total wealth. he's smart :)

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    1. Certainly possible, Marco, but if so he is being more than slightly hamfisted about it.

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  10. Good to see that people seem comfortable with Bernanke determining total wealth....

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