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
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.