QE3: What it Really Means

BY Paul Solman  September 20, 2012 at 1:26 PM EST

 A pressman inspects the roll out of $20 bills
A pressman inspects the roll out of $20 bills. Photo by: PAUL J. RICHARDS/AFP/GettyImages

Last week was a momentous one for world markets and the world economy. Since thousands of you now read this page daily, I feel some obligation to comment.

Last thing’s first. The significance of the Fed’s action last week was not the announcement that short-term interest rates would be held low for years, nor of QE3 – “quantitative easing,” round 3. QE3 merely entailed the “news,” more and more openly anticipated, that the Fed would create more money — $40 billion a month’s worth. Slightly unexpected was the announced use of that money: to buy Fannie Mae and Freddie Mac bonds in an effort to keep mortgage rates low and pump up the housing market. The idea here: to eliminate housing debt so that Americans will be able to pick up their spending and revive the economy.

But the surprise was Chairman Ben Bernanke’s unequivocal commitment to continue the announced policies for as long it takes to bring down unemployment, which Bernanke had recently called a “grave concern.” Moreover, there was but one dissenting vote on the Fed’s 12-person Open Market Committee.

For all the hoopla, though, and the buoyant response from markets at home and abroad, Bernanke did not do something more and more economists have been urging and that we’ve been reporting on for years: lower the IOER – the rate the Fed has been paying financial institutions to redeposit their newly minted Federal Reserve money with the Fed. Despite the talk of the Fed flooding America with dollars, most of the electronic money it has created since the Crash of ’08 has gone right back to the Fed. Below is a Fed chart of “recent trends” in the Fed “balance sheet” since the Crash and below that, what the current Fed “balance sheet” looks like.

Without a reader-numbing crash course in bank accounting, suffice it to say that “Assets” are what a bank owns; “liabilities,” what it owes. You know, of course, what a bank mainly does: take in deposits and loan out something like 90 percent of the money, charging more for the loans than it pays to depositors. Thus what a bank owns are chiefly its loans: promises from its borrowers that they will pay back what the bank has loaned them. What a bank owes is mainly its deposits: money the bank promises to pay back to others.

Note that the vast bulk of the Fed’s assets are “Securities held outright”: $2.5 trillion. Of these, $1.65 trillion are US Treasuries, i.e., Treasury bonds; the other $850 billion, “mortgage-backed securities,” guaranteed, the Fed says elsewhere, “by Fannie Mae, Freddie Mac, and Ginnie Mae” and thus by the US government.

And what about the Fed’s “liabilities”? Well, more than half of the total are “Deposits” ($1.58 trillion) and almost all of them are “term deposits held by depository institutions,” better known as “banks.” And there you have those “excess reserves” I keep writing about. It’s that trillion-and-a-half that banks have redeposited at the Fed, which keeps paying them .25% to do so. Were the Fed to lower or eliminate the interest on these excess reserves, the banks would presumably be forced to lend them out. It remains hard for some of us to see why the Fed has kept the payment in place.

At this point, I was going to discuss the European quasi-equivalent of the Fed, the European Central Bank (ECB) under Mario Draghi, who also acted momentously last week, or at least promised to. But enough for now. Perhaps I’ll get to “Super Mario” tomorrow.