QEII, Like QEI, Isn't Monetary Ease

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As is well known now, the Bernanke Fed is set to begin another round of so-called "quantitative easing" in order to stimulate demand.  Unfortunately for Bernanke & Co. simply adding liquidity to an economic system does not promote growth. In fact, the relationship is reversed: it is new demand that stimulates the need for new liquidity, not liquidity that sparks demand.

A simple analysis reveals the above in living color. 

Back to QE1, it's no secret that the latter drastically altered the Fed's balance sheet. As of October 20th, the Fed's balance sheet stood at $2.3 trillion of which $824 billion was held in U.S. Treasuries and $1 trillion was in mortgage backed securities from Fannie, Freddie, and Ginnie. Other smaller assets include the $66 billion Maiden Lane entities (created to house Bear Stearns and AIG wreckage), $20 billion of credit extended to AIG, and $26 billion in AIA Aurora and ALICO (created to hold AIG stock).

To provide a reference point as to how the Fed's balance sheet has changed as a result of QE1, the central bank's assets moved within a range of $739-943 billion between December 2002 and January 2008 versus $2.3 trillion today. So where did over $1.4 trillion of new liquidity go?

As the Fed's website states, "the expansion of Federal Reserve assets that has resulted from the aggressive response to the current financial crisis has been matched by an expansion of the Federal Reserve's liabilities, particularly the deposits of depository institutions." Loosely translated, because the cash from QE1 has not stimulated demand, banks simply deposited the cash back at the Fed.

Obviously, the liquidity created from QE1 can't be stimulating demand if it's sitting dormant in Fed coffers, so why would QE2 be any different? As the relationship between the Fed's balance sheet and currency in circulation shows, new liquidity is not the driver of consumption that its advocates presume.

‘Currency in circulation' is the technical term on the Fed's balance sheet for the demand for money. When currency in circulation is a large percent of the Fed's total balance sheet, it means the economy is growing because the demand for goods and services is strong such that individuals require money to make

Conversely, during periods of slower growth, currency in circulation as a percent of the balance sheet falls in concert with reduced demand for money.  When money demand is low, excess cash accumulates at the banks and those reserves are deposited at the Fed where they earn a low, risk-free return.

From December 2002 to December 2007 when the economy was growing, on average 90% of the Fed's balance sheet was represented by currency in circulation and only 3% was deposited at the Fed as reserves. As of October 20th however, only 41% of the Fed's balance sheet was currency in circulation and 42% was reserves held at the Fed. The large shift away from the 90% benchmark of growth indicates that despite QE1, demand is still very weak and people are not using the excess liquidity pumped into the system.

Looking at the overall growth of the Fed's balance sheet versus the growth of currency in circulation also proves the point. On January 2, 2008 before the specter of a crisis and when the Fed's balance sheet was a more normal $739 billion, currency in circulation was $829 billion. Today, with a Fed balance sheet of $2.3 trillion, currency in circulation stands at only $961 billion.

So while the Fed's balance sheet has grown by over 300%, currency in circulation is only up 16%. Additionally, since as much as two-thirds of U.S. dollars in circulation are used overseas to lubricate economies with less stable currencies, the growth of currency in circulation inside the U.S. economy is likely to be far below 16%.

No matter how you look at the data, it's clear that quantitative easing does little to stimulate the economy and impact demand. The fact that QE1 is not in the economy, but is sitting as deposits at the Fed shows the worthlessness of balance-sheet expansion when it comes to stimulating demand.


Sammy Abdullah is an analyst with Prudential Capital Group in Dallas, TX.  Feel free to email him with comments at sammyabdullah@gmail.com. 

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