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November 08, 2014, 06:17:42 PM |
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When evaluating the inflationary impact of QE, its important to consider that QE can occur in two ways. The impact of each can be different. In the last few years central banks have been primarily buying bonds from banks, which may not be as inflationary as people expect, in the short to medium term.
1. The central bank buys government bonds from a commercial bank. This appears to have little impact on the economy and really only effects the accounts of the two entities. The central bank buys the bonds from the commercial bank and in the process creates deposits, (just like how a bank makes a loan to you or me). These deposits are treated as reserves by the commercial bank. For example if the Bank of England purchased £10m of bonds from Barclays the Balance sheet impact would be as follows.
a. Barclays has swapped one asset for another, it has swapped bonds for reserves, the size of its balance sheet does not change
b. The Bank of England has expanded its balance sheet, it now has a new asset, the bond and a new liability, the money it owes to Barclays
2. The central bank buys government bonds from a non-bank institution. Here the situation is a little more complex. Let’s say for example the Bank of England buys a £10 government bond from a private individual Mr Smith (in reality it is large insurance companies or asset management institutions). The Bank of England writes a cheque to Mr Smith in exchange for the bond. Mr Smith is not going to just keep this cheque and do nothing, therefore Mr Smith immediately goes into his normal commercial bank, say Barclays and deposits the cheque. Now Barclays has £10 more reserves because the Bank of England owes Barclays this money. In reality of course, this all happens on instantly computers, there is no cheque. The accounting treatment is as follows:
a. Mr Smith has swapped one asset for another, he had a bond and now he has bank deposits. His balance sheet remains unchanged
b. The Bank of England has expanded its balance sheet, it now has a new asset, the bond and a new liability, the money it owes to Barclays
c. Barclays has expanded its balance sheet, it has a higher level of reserves which is an asset and it has increased its liabilities, which is the deposit.
I think it is vital to understand the dynamics of QE as these two mechanisms have different outcomes. Method 1 merely helps banks out in a major liquidity crises. Method 2 increases bank deposits, Mr Smith has money which he is likely to spend on something. This is likely to boost the economy and may be inflationary.
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