Daily Archives: July 14, 2011

The market is talking about QE3 again after last week's shock miss on US payrolls. Those who think it's coming are pointing to the minutes of the last FOMC meeting as evidence in support of their case as they noted that "some" Fed officials said some more easing might be need in the unemployment rate doesn't start moving down and inflation returns to low levels. That latter part is the important one, as I think most folks right now will have a hard time suggesting we're in a low inflation environment and "a number" of Fed officials see the inflation risks as biased to the upside.

In other words, if you're expecting QE3 you may not want to hold your breath. One of my colleagues here actually thinks it would take the stock market falling about 20% to spur Bernanke & Co. into action. That would put the S&P 500 on the way down to 1000. I wrote a post recently on stock traders positioning themselves bullishly because they expected the Fed to protect their downside with more QE. Not sure how they'd be feeling 20% down. On the plus side, if that were to happen, it would likely mean the dollar had strengthened a fair bit, giving the Fed some market cover to do further easing.

But guess what? The Fed is actually tightening right now.

Follow me here.

The Fed has indicated its intent to roll over maturing securities to maintain a steady balance sheet. That means when they receive the principle back on a bond or note they are holding, they turn around in use the proceeds to buy Treasury securities. That's why you'll continue to see the Fed doing their reverse auctions periodically. What that will serve to do is slowly shift the composition of the holdings away from mortgage and agency paper to Treasury debt.

But here's the rub. The Fed hasn't said anything about reinvesting the income they get from those holdings – the periodic interest (coupon) payments. The income the Fed makes from those interest payments is largely getting passed along to the Treasury as part of its annual remittance of excess profits. That's been tens of billions of dollars in recent years because of the size of the Fed's balance sheet.

The money supply math of the Fed is that when it buys securities from the market it prints money, thus increasing the money supply (at the monetary base level). Flipping that around, when the fed sells securities to the market (as it's expected to do when it finally gets around to unwinding QE) it drains money from the market. When the Fed is repaid its principal the money supply is reduced, so it goes out and buys more to keep the money supply level.

Interest payments to the Fed are just like principle repayments in terms of reducing money supply. It's money from the market that goes to the Fed and is effectively destroyed. These interest payments are not being reinvested, so the money supply is slowly drained from the system.

Now, by comparison, these interest payments are a small fraction of the total money supply (only a few % given interest rates), so it's not like we'd expect to see a major drop in M2 money supply as a result. Also, as the mortgage and agency holdings are slowly converted to Treasury holdings through the mature-and-reinvest process, the impact of the drain will decline. This is because the mortgage and agency interest is coming from the private sector while interest on Treasury debt is government money which isn't part of the private sector money supply, and is largely returned to the government anyway.

Obviously, the small relative size of the interest income makes this money supply drain little more than a trickle (though tens of billions does sound like a lot). My point isn't that the Fed has engaged in a noteworthy stealth tightening since ending the QE2 purchases. It's more than we need to make sure we understand the mechanism of things to know what's really going on.