Why QE2 Didn't Work

QE2, the Federal Reserve's bid to boost the economy by buying $600 billion of Treasury bonds, ends this month.

Get ready for an earful of commentary about why it failed over the coming weeks. You'll hear it all: It didn't boost the economy. It did boost commodity prices. It didn't bring down unemployment. It did lower confidence in the Fed.

To save some time, this chart tells you most of what you need to know:

Source: Federal Reserve.

After printing a little less than $600 billion during QE2, excess reserves have increased by ... a little less than $600 billion. There's a good chance that by the time QE2 officially ends, excess reserves will have increased by exactly the same $600 billion that QE2 printed.

What are excess reserves? They're cash deposits banks hold at the Fed above and beyond what's mandated to pad their balance sheets. Cash parked in excess reserves hasn't entered the economy. It doesn't increase the money supply. It hasn't been lent out to businesses. For practical reasons, it barely even exists. All the money the Fed printed during QE2? The economy barely saw a dime of it.

Here's basically what happened: The Fed bought Treasury bonds with money it created with a computer stroke. The seller of those bonds took the cash proceeds and put them in the bank. The bank then took that cash and gave it back to the Fed.

The net result on money supply? Peanuts. That's the first, and main, reason QE2 failed.

But that doesn't mean it didn't have an impact. QE2 may have indeed juiced the prices of stocks and other assets. Investors who purchased Treasury bonds before QE2 were likely crowded out of that market while the Fed lapped up as much debt as it could. Where did those investors go over the past eight months? Money that used to buy Treasury bonds may have been pushed into stocks, gold, silver, oil, who knows what else. But with the Fed about to back out as the largest buyer of Treasuries, those crowed-out investors might be about to return to their old digs in the Treasury market. This may be why, counterintuitively, interest rates rose after QE2 began, and may very well drop after it ends -- the opposite of its stated goals. That's the second reason QE2 failed.

So what happens now? Forecasting economic growth is on par with picking lotto numbers. But here's a bet: The next eight months will be slower than the past eight. A quantitative easing program might work if it gave an economy momentum by the time it ended. But that isn't the case right now. GDP growth is minuscule, and jobs growth, while not bad, is barely enough to make a dent in the ranks of the unemployed. Housing -- usually a key driver of economic growth -- is face down in the mud and sinking lower.

The big question is what happens with all those excess reserves. Banks like Bank of America (NYSE: BAC  ) , Citigroup (NYSE: C  ) , and Wells Fargo (NYSE: WFC  ) could theoretically lend them out, which would bring new cash into the economy, increase the money supply, and kick inflation into high gear.

Right now, that isn't much of a risk. There isn't enough loan demand. Banks couldn't lend a meaningful amount of their excess reserves if they wanted to. No one wants to leverage up after the wrath of 2008. Once bitten, twice shy, you know.

Someday that will change, and excess reserves will weasel their way into the economy. But when? This year? Probably not. Next? Don't count on it. But it will. When it does, two realistic outcomes exist: The Fed will have to unwind QE2's legacy by raising interest rates, selling assets, and maybe even raising bank reserve requirements. Or, as Warren Buffett put it, "one likely consequence is an onslaught of inflation."

Until then, we wait. In the meantime, it's clear that whatever QE2 was supposed to do, it didn't.

Fool contributor Morgan Housel owns B of A preferred. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Wells Fargo. The Fool owns shares of and has opened a short position on Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (7) | Recommend This Article (11)

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  • Report this Comment On June 08, 2011, at 6:12 PM, xetn wrote:

    Why would the banks lend to anyone when they can just park their reserves at the Fed and earn a .25% return without any risk.

  • Report this Comment On June 08, 2011, at 6:14 PM, TMFHousel wrote:

    ^ Because they can earn higher risk-adjusted returns elsewhere.

  • Report this Comment On June 08, 2011, at 10:30 PM, MMTInvestor wrote:

    Morgan,

    First, it's irrelevant that there are so many "excess" reserves because commercial banks don't lend reserves. Period. Reserves exist for two purposes only: to settle payments and to satisfy legislatively-mandated reserve requirements. Some countries, btw, such as Canada and Australia, don't even have reserve requirements!

    Banks initiate loans which create deposits, and reserves are generated by a keystroke as a contemporaneous byproduct (they "supervene" on the economic activity itself, to be philosophical about it). Reserves are the FORM endogenous credit money takes, but they are not (and their mere creation cannot induce) economic action itself, such as the creation of a loan. Banks are capital-, not reserve-constrained in their lending policies; the traditional money multiplier is a myth. (See this piece for a popular explanation: http://pragcap.com/the-myth-of-the-money-multiplier-a-follow... Thus, as a few Fed governors have recently admitted, there is no transmission mechanism for excess reserves to "make their way" into the real economy. The widespread belief that banks lend reserves is one of the biggest misunderstandings of modern monetary mechanics in the last 40 years.

    Second, when the Fed does unwind the LSAP programs and sells ABSs and Treasurys back to the primary dealers, guess what they will use to purchase those bond securities from the Fed? Yep, the very same excess reserves the Fed used to pay for them in the first place.

    So, you can see why "excess" reserves remain on bank balance sheets.

    Few who can access credit are seeking it because there's little demand in the economy to spur sales growth (or if they're corporate America, they can just tap the debt markets at fabulous rates); and those who want/need credit cannot get it because they have negative equity on their collateral and face tougher standards. Hence, among other reasons, very little loan growth on a net basis.

    QE2 was a massive mistake and was always pushing on a string. It was never inflationary, aside from transitory market psychology, and actually exacerbated the debt-deflationary tendencies of our economy by removing tens of billions in interest income from the private sector and by inducing false commodity price signals via portfolio re-balancing and risk chasing to hedge against an inflation that will soon have proved to be a mirage. The latter has only crimped the middle class and hurt corporate profit margins.

    Bernanke's tenure is replete with monetarist gaffes. He should resign yesterday.

    All the best,

    Scott

  • Report this Comment On June 08, 2011, at 11:10 PM, dave665 wrote:

    The real driving force behind inflation is government spending beyond its means. When real production of goods in the private sector is stagnant or decreasing, but government spending continues to increase, you have more dollars chasing fewer goods. QE2 enables this spending to continue without having to find a real lender. Then, down the road, you are stuck with either higher interest rates (to keep lenders/investors interested in all those bonds), or a new round of money creation to keep buying them. Inflation is ultimately in the hands of our elected officials, and balancing the federal budget is the only way to keep the dollar stable.

  • Report this Comment On June 09, 2011, at 9:41 AM, miteycasey wrote:

    Plain, straight forward, and easy to understand.

    Great article.

  • Report this Comment On June 09, 2011, at 11:02 AM, deckdawg wrote:

    Which interest rates rose after QE2 began? 2 & 10 yr Treasuries have been hitting record low yields. I'm just about to close on a re-fi of my house at 3.75% for a 15yr fixed mortgage. Are there other rates that are up?

  • Report this Comment On June 09, 2011, at 4:26 PM, DJDynamicNC wrote:

    Anything I could have posted here, Scott already said better in his comment above.

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