1
$\begingroup$

In light of the recent unease about interest rate rise, I've been taking a growing interest in how our economy actually works, something I've been trying to avoid. So this forum is a way for me to clarify my (mis)understanding, so for some of you, I'm sorry for stating the bloody obvious.

Banks stopped borrowing money when people or corporations or even other banks defaulted on their loans. Banks even stopped lending to each other. As a result the economy wasn't growing. So to avoid another recession (or encourage spending in the current recession), the Feds decide to experiment with QE.

With their unlimited power, they created new money into being, and bought these debts, even bad debts (bonds) and equities/assets from these banks.

My focus is on the bonds that the Feds bought, and this is where my understanding starts to get fuzzy and wtfs/minute grows exponentially....

So these banks sold their bonds to the feds, and with this new loan they received, they can start lending back to people or corporations. But this also means they are paying interest rates to the Feds, but hopefully they are making good investments on the new loan (but what if they default on this new loan, rinse and repeat???)? Because Feds have been introducing these magical money for years, bond prices were up, and thus interest rates decrease...

Quantitative tightening... But cheap money is unsustainable and cannot go on forever (I'm still unclear on this but I will research more on this later). So now the Feds are thinking of selling back the bonds (and presumably equities) they bought from the banks that sold it to them. Now, bonds price will plummet but interest rates will rise...

My question for now is:

Will the Feds now pay the banks interest rates on money that THEY magically created or are they exempt from this?

Do banks really really have to buy these bonds bank? Then interest rates just won't rise and the Feds are stock with bad debt until maturity, and it's essentially paid for, more or less.. What am I not understanding?

$\endgroup$
  • $\begingroup$ I suggest that you edit your question and eliminate the speculative discussion at the beginning, and instead only focus on what you are specifically asking about. I realise that you are learning about the subject, but the initial description of QE contains a few points that are either questionable or outright incorrect. That makes it difficult to address the actual question, as correcting earlier statements would distract from what you are interested in. $\endgroup$ – Brian Romanchuk Feb 12 '18 at 17:43
  • $\begingroup$ Thanks Brian, but that's why I wrote them so I can be corrected! $\endgroup$ – Lews Therin Feb 13 '18 at 8:16
  • 1
    $\begingroup$ The problem is that this website format needs very specific questions. Feel free to ask several questions; just keep each tightly focussed. That way you can attract better answers, as the questions are easier to answer. There’s a number of other QE questions, and the answers give some background. I added links to a couple of them. $\endgroup$ – Brian Romanchuk Feb 13 '18 at 11:48
2
$\begingroup$

The question as it stands now contains points that are debatable. So I will just attempt to answer a similar question; the question could be revised in response.

There are a number of other questions on QE that offer some background.

My revised version of the question is: “In quantitative tightening, the Federal Reserve sells bonds on its balance sheet. Can banks refuse to buy these bonds?

The answer to that question is yes, but it does not matter. Note that my description here is highly simplified, technical details are being skated over.

Let’s assume that Betty is an investment dealer, but not a bank. She has a bank account at Acme Bank. The Federal Reserve has an auction to sell bonds. Acme Bank refuses to participate for some reason or other, but Betty buys \$1 million in bonds from the Federal Reserve.

Betty transfers the money on deposit at Acme Bank to the Federal Reserve. What then happens.

  • Acme Bank reduces Betty’s deposit balance (at Acme) by \$1 million.
  • Acme Bank transfers the funds to the Federal Reserve by losing \$1 million of reserves it had on deposit at the Federal Reserve. This eliminates \$1 million of excess reserves in the system.

These operations are neutral for Acme itself. It loses an asset (the reserves), but also loses a liability (Betty’s deposit).

That is, bank reserves are just deposits by banks at the Federal Reserve. A central bank is called a central bank for a reason - most banks have deposits there. It’s just that in American banking jargon, these deposits are called “reserves”. Other countries (like Canada) have abolished resserve requirements, and these deposits are just called “settlement balances.”

Reserves are destroyed by anyone transferring money to the Federal Reserve. The only way a bank could stop it is by not transferring the money, which would be a breach of some law or another.

The only way that quantitative tightening could be stopped is if nobody was willing to buy Treasury bonds at any price. Unless the Treasury was on the verge of default, we normally do not see such behaviour.

$\endgroup$

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.