How the Fed “Prints” Money

With the Reserve Bank of Australia recently musing about the potential of engaging in unconventional monetary policy to combat growing weakness in the Australian housing market, there will almost certainly be a renewed focus on Quantitative Easing (QE) on a forward-going basis. Taken in conjunction with the fact that central bankers around the globe have openly started discussing walking themselves back from the current tightening cycle, and it is becoming obvious that the fragility of the current economic expansion based on past QE measures is starting to look more than a little long in the tooth. As such, it would be little surprise to hear renewed and increasingly vocal calls for the re-implementation of QE once it becomes obvious that current interest rates are not yet high enough to allow sufficient room for rate cuts to front-run the next recession.

Due to the confusion among many analysts regarding what QE actually is and what it isn’t, a re-explanation of the mechanics of Fed asset monetization would seem to be in order. It has become obvious over the last decade that many market pundits simply do not understand the mechanics of QE, which leads them to claim that the inflationary impact of the Fed’s asset monetization program on the economy is dependent on commercial bank lending and their ability to expand loan portfolios to grow the money supply.

The source of the confusion lies in the fact that the vast majority of people believe that when the Fed buys bonds in the private market, the only thing that happens is that newly-created money is added to the reserves of commercial banks. As the logic goes, the process of adding to commercial bank reserves is in itself not inflationary since bank reserves are not actually spent and are not counted as part of the money supply. In order for the money supply to expand, it is up to the commercial banks, backed by more reserves, to create new money and liquidity by extending credit and expanding their loan portfolios through the identification of good investment opportunities spearheaded by credit-worthy borrowers. The newly-created reserves, it is argued, provides “backing” for greater loan growth, unshackling commercial banks from their previous lending constraints based on either inadequate reserves or overly-restrictive reserve requirements.

According to these pundits, during times of recessions, banks tend to look suspiciously at borrowers through a risk-adverse lens, having the potential to become the clog in the monetary transmission mechanism of money from the Fed into the private sector if they pull in their horns and simply sit on their reserves. This has allowed many analysts to claim that QE has not been excessively inflationary, since all the Fed-created money is simply sitting in commercial bank reserve accounts held at the Fed rather than flowing out into the broad economy.

Having now covered the widely-held belief of how QE works and why it supposedly does not equate to the Fed “printing” money, it is time to explain how QE actually works. The problem with the above explanation of QE is that it turns out to be only partially true in that it leaves out half the story. This was explained in Michael Pollaro’s excellent explanation in 2010 of the mechanics of QE, which can be summarized as follows.

When the Fed purchases a bond as part of QE, it does so by writing a check (against itself) made payable to the seller of the bond – typically an arm of a commercial bank referred to as a Primary Dealer. When the Primary Dealer subsequently goes to deposit this check in their bank account held at, say, Greedy Bank, deposit money is created and added to the bank account that the Primary Dealer holds at Greedy Bank. But the creation of the deposit money has created a liability for Greedy Bank, and in order to offset the liability with an equivalent asset, Greedy Bank submits the check to the Fed and is subsequently paid in the form of an increase to its reserve account held at the Fed.

In the above transaction, the Fed has created “covered money” in the sense that for every dollar spent to purchase bonds as part of their QE program, a dollar is added directly to the money supply and a dollar is added to commercial bank reserves held at the Fed. The QE process is therefore not dependent at all on lending by commercial banks – it adds directly to the money supply through the creation of deposit money within the bank accounts of the primary dealers. While analysts are indeed correct that the process of QE adds reserves to the banking system, they are mistaken to believe that the process does not also constitute a direct injection of funds into the money supply. The process under which asset monetization is currently performed means that the Fed always has the ability to add or subtract directly to or from the money supply at will.

This process is evident in the observation that since the Fed began its QE program following the Great Recession of 2008, the total money supply has increased by a far greater amount than the increase in commercial bank lending could explain by itself. Without the Fed directly increasing the money supply through asset purchases under their QE program, where else, we ask, did the remaining money come from? It certainly did not come from the creation of bank reserves held with the Fed, since as was mentioned earlier in this article, reserves are simply not counted as part of the money supply. The only other explanation turns out to be the correct one: as part of the QE process, the Fed injected money directly into the economy in the form of deposit money given to the Primary Dealers in exchange for treasuries. This, at the end of the day, is the process by which the Fed “prints” money.