In this piece I will briefly overview how the Federal Reserve’s Quantitative Easing policy works, and discuss whether these large scale asset purchases are inflationary, helpful, or simply bureaucratic largesse for the political elite.

It is first imperative to understand the notion of a hierarchy of money, and what form money manifests itself as at each level in the hierarchy. When we think about money, we usually refer to the currency and bank deposits, both of which are merely one block of the pyramid.

At the top of this pyramid are bank reserves, and they are distinctly different than money we think about in our every day lives. Reserves, replacing gold since the end of the gold standard, are liabilities to the Federal Reserve and serve as the medium of exchange for banks. Reserves are used to settle interbank transactions. Reserves, for the most part, are simply bank ledger and are not used in the real economy.

The next level are bank deposits, which are liabilities of the commercial banking system and serve predominately as money in the real economy. This along with physical currency, which is a liability of the central bank, is what we typically consider money.

This hierarchy becomes more complex with the introduction of the Eurodollar System and the wholesale financial system. As I’ve written previously, many institutional cash pools cannot hold their vast sums of money as deposits and elect to safeguard their wealth in U.S Treasuries and other forms of high quality, liquid assets. Furthermore, many banks use these safe, liquid assets (preferably U.S T-bills) as a form of funding through repo transactions. This repledging and rehypothecation of collateral is the backbone of credit creation and liquidity in the financial economy. Collateral has its own hierarchy as well, relating to the quality of the collateral, with the collateral multiplier and haircut on the collateral dictating the general magnitude.

Going back to QE, in the most basic sense, the central bank expands both sides of its balance sheet to buy Treasuries from Primary Dealers. For the Primary Dealer this is merely an asset swap, swapping Treasuries for reserves.

The balance sheets of the Fed and Primary Dealer in Step 1 of the basic QE process

These Primary Dealers act as intermediaries and help allocate liquidity needs in the financial economy, so the reserves obtained would then ostensibly be repoed out into the commercial banking system.

The Primary dealer goes into the repo market as a counterparty

Here we can see that the net result is an asset swap, wherein U.S Treasuries were swapped for Reserves. Considering how fungible and integral collateral is to credit creation (money creation) in the financial economy, there has been no meaningful expansion in the money supply in this scenario. If anything, stripping away pristine collateral from the system puts unnecessary strain on the stability of the entire system as the collateral multiplier is forced to increase in order for the banks to stay afloat in their day to day operations.

An important caveat to this non money printing money printing is when the Fed or any central bank buys Treasuries from a non bank entity. Joseph Wang, or commonly known as Fed Guy recently illuminated this distinction. If the original seller of the US Treasury is a non-bank entity, there will be additional bank deposits in the system, in effect increasing the money supply at the real economy level. In the diagram below I will refer to this non-bank entity as Seller.

A stylized abstraction of balance sheets when a non-bank entity sells US Treasuries to the central bank

The blue lines and numbers follow the flow of the U.S Treasury, as it goes from the Seller, to the Primary Dealer, then ultimately the Fed. The orange lines and numbers indicate the opposite side of this transaction, showing the flow of reserves to the Primary Dealer, wherein reserves make their way to the commercial bank and ultimately the Seller’s Bank. The seller bank then makes deposit liability and issues the $100 to the Seller.

The crucial distinction here is that the U.S Treasury does not reside on the balance sheet of the Seller’s Bank, because the non bank does not have an account at the Fed and thus cannot accept reserves, so an additional bank deposit must be made by a bank that does have an account at the Fed. So while the previous example was merely an asset swap, here there is the creation of a bank deposit.

These bank deposits will typically go to pension funds or hedge funds, not commercial businesses or consumers. Meaning that much of this increase in the money supply will not be put towards productive measures like investment, rather simply be spent in the obtainment of different financial assets, like stocks. So while one part of QE does increase the money supply, it only serves to inflate asset prices and increase wealth effects, or more colloquially put, enacting trickle down economics.

In the best case scenario QE can create additional bank deposits in the commercial banking system. However, much to the chagrin of those who claim QE is hyperinflationary, that is only a theoretical possibility. In practice it is very doubtful that QE in this paradigm would achieve the inflationary results that the Fed pertinaciously believes. When QE is conducted through banks, the key result is financial instability through the stretching of the collateral multiplier and extraction of pristine collateral. On the other hand, when bank deposits are created, they mainly benefit Wall Street as asset prices increase, disrupting price signals and further detaching asset prices from real economic factors and conditions. Needless to say, Quantitative Easing is far from the paragon of monetary policy that the Fed imagined it would be.

It is true that a rising tide lifts all boats, and I believe that much of the dismay over inequality is inappropriately placed, or at least misguided. However, it cannot be gainsaid that the financialization and state intervention of the economy has severely hindered prosperous growth, and programs such as QE only serve to raise the height of the dam that keeps the financial economy and elites rising higher and higher. While the real economy and middle class sulk in stagnant water.