1994 again?

Many commentators regard Quantitative Easing as ‘printing money’ and indeed a few hundred years ago, when cash in the form of coins or IOUs (i.e. bank notes) made up the bulk of the money supply, printing money could work well but today the volume of physical cash is only the equivalent of around five or six percent of the total money stock.

Instead, the vast majority of money in a modern economy is bank money or more properly bank deposits. Indeed when one thinks of someone’s liquidity, one thinks of their cash, their deposits and untapped credit, and given this situation, the generic term “money printing” must now include anything which expands people’s ‘liquidity’, including therefore their cash, their deposits and their access to credit.

At present, ongoing regulatory tightening, the collateral famine and commercial banks’ own more cautious stance are reducing access to credit and this implies that the only way in which authorities can expand people’s ‘liquidity’ at present is to create more bank deposits. However, to create more customer deposits in the banking system, it is necessary to expand (or at least reconfigure) the balance sheet of commercial banks in which ‘real’ customers hold deposits, and in practice, private individuals, companies and non-bank financials cannot hold deposits at the central bank. Hence, when we today talk about printing money, what we need to see is expansion not so much in central bank balance sheets but rather expansion in balance sheets of commercial banks.  In a sense, and contrary to popular misconceptions, central banks’ balance sheets are the least important in the system and this makes the notion of ‘printing money’ a great deal harder to achieve than simply printing a few more bank notes. For example, if we consider the basic and currently typical QEP regime under which a central bank finds itself buying (government) bonds, then this need not lead to the creation of more customer bank deposits within the economy. Thus, if the central bank purchases bonds from domestic non- bank residents of the country, such as private savers or companies, then the vendors will receive a credit to their bank accounts, and they will consequently have more liquidity – the aim of the exercise. But if the central bank merely buys bonds from other banks, who then simply hold the funds received in the form of excess reserves at the central bank, then all that will have happened is that the central bank’s balance sheet will have got larger but the commercial banks’ balance sheets will be the same size, implying no increase in ‘end customer’ bank deposits and hence no increase in what we might term macro liquidity. This way the central bank may succeed in altering bond and even other asset prices by changing relative supply and demand conditions in specific markets but it will not directly impact actual liquidity conditions in the wider economy.

Therefore, we can argue that the ‘best’ QE is one that encourages commercial banks to expand rather than one that merely results in expansion of central banks’ balance sheets. In addition, if we want to ‘measure’ the effectiveness of central banks’ own actions on raising liquidity, we must adjust for any reserve hoarding by commercial banks that in effect counteracts central banks’ own purchases. In studying aggregate net buying of government bonds by the FRB, ECB and the BoJ adjusted for changes in excess reserves, and also commercial banks’ own outright purchases of government bonds in these countries, two things stand out. First, despite a notable increase in central banks’ own purchases of bonds over recent months (the FRB is now buying around $100bn per month and the BoJ around $90bn), the impact on the level of liquidity is neutered by a sharp increase in commercial banks’ holdings of excess reserves at central banks with the result that aggregate net liquidity added by the combined actions of the central banks seems to be closer to $100bn, at least from the perspective of the wider economy. Secondly, commercial banks, having previously been significant buyers of government bonds, have started to become significant net sellers. As a result on an adjusted net basis, the G3 banking systems as a whole probably sold $60-$100bn of bonds in both April and May. Three months ago, the banking system in its entirety was creating around $130bn of new liquidity every month by monetizing government bonds. Today it is destroying almost the same amount each month. It looks that this is what has caused the change in the environment within the bond and other asset markets over recent weeks.

So we can conclude that significantly, although central banks are still undertaking QE, an increase in reserve hoarding by commercial banks and a shift towards divestment from bond markets by commercial banks has led to what is in effect an unwinding of QE. What’s more this shift has not involved gentle tapering and as a result we are starting to see the sort of behaviour observed in 1994, despite central banks’ continued expansionary stance.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla