Sunday, January 19, 2014

Could the Taper of QE3 Be Stimulative?

If we start with long term total bank assets:
FRED Graph

We see a fairly stable growth, with some slowdown during recessions.  There was a peak in 2008 relating to Fed liquidity maneuvers, including interest on reserves (IOR).

First, I want to propose that QE2 and QE3 may have had little effect on this growth rate.  My reasoning here is that with IOR and very low interest rates, reserves and treasuries are basically perfect substitutes.  If the main result of QE is to add reserves to the banking system, this should not affect total bank assets, because the banks should simply swap reserves with other low risk assets to suit their needs within the level of assets they already were intending to hold.

Here are some major portions of bank balance sheets, as a percentage of total bank assets:

FRED Graph
Real Estate Loans, Commercial and Industrial Loans, Treasury and Agency Securities, Cash
Treasury Securities and Commercial and Industrial Loans show typical cyclical behavior.  Reserves appears to have substituted only a very small amount for treasuries and agency securities.  The asset that most of the excess reserves appears to have replaced over the period as a whole is real estate loans.

There has been a huge increase in all-cash and institutional buyers in the housing market.  The net effect of QE appears to be that the Fed is buying treasuries and agency debt from non-banks.  Those treasury and MBS sellers, on net, are replacing their would-be treasury and MBS holdings with residential real estate, which is now being funded outside the banks instead of through mortgages.  And the cash ends up in the banks.  So, to a large extent, once the QE funds end up as bank reserves, they appear to have mostly served to move real estate assets from bank balance sheets to non-bank balance sheets.
But, I think there is a difference in character between QE2 and QE3.  Here is a chart of the change, in dollars, of various bank assets, compared to Fed Securities holdings:
The banks have absorbed the reserves with seemingly little adjustment, when viewed in absolute dollars.  Total low-risk assets (red line) move in concert with Fed purchases (grey background).

When we subtract cash, treasuries and agency securities from bank assets, the net bank asset level bottomed out during QE2, and then increased during the period between QE2 and QE3.  At the same time, Commercial and Industrial Loans bottomed out, and also started its cyclical recovery.
Before QE2, bank assets were stagnant and banks were reducing private credit in exchange for more treasuries.  These items leveled out during QE2 and total assets grew at roughly the rate of new reserves coming in from Fed actions.  After QE2, total bank assets continued to grow, and it appeared that bank assets, net of cash, treasuries, and agency debt, were starting to grow, but, this growth stopped when QE3 began.  For about 15 months between QE2 and QE3, bank assets increased by about $500 billion, and this was with a flat level of reserves + treasuries + agency debt.  In the 15 months since QE3 began, bank assets increased by about $1.2 trillion, but it has all gone to reserves.
QE3 has some weak inflationary effects, but I wonder if we have reached a point where reserves are crowding out bank balance sheets in a way that is stifling the development of private credit.  With that in mind, here is a graph comparing Commercial and Industrial Loans as a percent of Total Assets to Commercial and Industrial Loans as a Percent of (Total Assets less Cash).
FRED Graph
Here is a graph of Commercial and Industrial Loans since Dec. 2010:
Could the taper actually help free up bank lending?  Is it possible that one of the stimulative effects of QE1 and QE2 was that private markets were willing to trade some of the treasuries for higher risk assets while the banks were still trying to add low risk assets but were unable to add to real estate loans?  If, by QE3, banks are more willing to increase credit risk exposure, but are capital constrained by the inflow of cash, is it possible that the net effect of QE3 (by moving investments out of the banks and into non-banks) is inconclusive?  On the other hand, will banks be able to recapture some of the mortgage market if Fed money stops flowing into housing through non-bank sectors?  I think it might be worth watching these measures move as QE3 is stepped down.
To the extent that QEs are shifting investment from commercial banks to non-banks, does anyone have a handle on the net effect this shift has on economic development, risk premiums, etc.?  If you have read this far, and you have banking expertise, your fee for reading this blog is to comment here and tell me if I'm making any stupid errors in my analysis.

Side Note:
This does offer a caveat to my interpretation of the 2000's housing boom.  I believe the housing boom can generally be explained with reasonable market behavior, with homes behaving as very long term inflation-protected bonds.  One piece of evidence in my narrative has been the bullish real estate market, post-2009, which has happened in the midst of a sclerotic real estate banking sector.  But, if we treat the cash inflow from the QE's as a substitute for the bank mortgage market, then funding markets for real estate aren't as dead as they appear.

FRED GraphHere is a Case-Shiller Index for the period.  Home prices seem to have accelerated during QE's that included MBS purchases.  They didn't accelerate during QE2, which didn't include MBS purchases.  I don't believe that minor liquidity effects on mortgage rates could have this much effect.  I think it's more likely that when the Fed entered the MBS market, the MBS investors that they replaced used direct cash real estate investments as a substitute for some of the MBS assets that the Fed was buying away from them.  I still think there is room for home prices to rise over the next decade or so in an environment of low real long term rates.  I see this price reaction as a result of a dead banking system that is undermining traditional demand in housing, so that prices are below the equilibrium price that would come from healthy supply & demand with a healthy credit sector.  QE has allowed non-bank investors to capture the gains from that disequilibrium.

If tapering Fed purchases of MBS means that, on net, there is a small disinflation effect, less money flows into real estate, and banks increase their Commercial and Industrial Loans, that doesn't seem like a bad trade to me at this point.  But if the banks can't take over funding of home financing again, then maybe the end of QE will again lead to disinflation.

PS:  I must not be obviously wrong.  Soberlook has the same idea.


  1. Some thoughts:
    Signaling effects of QE are expansionary, and tapering is negative in this sense. Fortunately the Fed has strengthened the forward guidance.

    Risk-bearing channel of QE works too, tapering is a clear negative too.

    Liability structure of the Fed is not optimal, and this is the cause of the very weak negative effect of QE you are describing. To fix QE, the Fed is testing a fixed-rate full allotment reverse repo program. With this program, regular banks would hold a smaller part of reserves, with the rest going to the shadow banking system.

    1. Thanks for your input, Vaidas. You are probably right that with all of those other factors, QE is still, on net, stimulative.

      What I'm getting at is that right now, $75 billion a month is being liquidated from treasuries and MBS and transferred into some combination of other assets - secondary equity markets, real estate, developing world debt, etc. I'm not sure if we know exactly where it's going, or what stimulative effects transfers to these alternate assets provide.
      In the meantime, banks are soaking up those $75 billion in reserves, and coincident with QE3, other bank assets have stagnated. Before QE3, banks were increasing their assets with credit risk by about $30 billion a month. If the stagnation in the growth of these other assets on bank balance sheets is related to the new deposits created by the new reserves, then QE could be preventing $30 billion a month in credit creation. Could $30 billion in freshly created Commercial and Industrial Loans, consumer credit, etc., be more stimulative than the $75 billion of various assets that are being bought by non-banks with the QE funds?

    2. Kevin:
      "Could $30 billion in freshly created Commercial and Industrial Loans, consumer credit, etc., be more stimulative than the $75 billion of various assets that are being bought by non-banks with the QE funds?"

      QE3 was associated with an increased supply of credit. To make these new commercial and industrial loans at a slower pace, banks had to ease their lending standards. On the other hand, after the tapering rumors, the pace of easing of standards has slowed.

      Now, if QE3 was designed better, with a more optimal distribution of reserves between banks and shadow banks, we would have seen even stronger increase in credit supply. But that is small potatoes.

      If anything, one could criticize QE3 that it led to supply of credit (and other risk bearing capacity) that is higher than optimal. For example, in early 2013 the estimated 10 year Treasury term premium has turned negative.

  2. See my related comment at Bill Wollsey's blog: