In part one of a two part series on quantitative easing contributor Michael Coote explains how central banks play games with investment risk premia

In part one of a two part series on quantitative easing contributor Michael Coote explains how central banks play games with investment risk premia

By Michael Coote*

Ever since the US Federal Reserve committed itself to quantitative easing (QE) in the aftermath of the global financial crisis, a high stakes game has been played by the major central banks, including the Fed, the European Central Bank, the Bank of England, and the Bank of Japan, all of whom have rolled out their particular versions of QE.

Making up money as you go along

QE occurs when a central bank “prints money” at its discretion in order to buy debt securities from the fixed interest marketplace.

QE is possible because central banks no longer back up – and thereby limit - their cash issuance with matching gold reserves, but nowadays issue “fiat money” by decree in any quantity they care to invent.

The transaction value of this fiat money is simply based on the good faith and credit of the government to which the central bank belongs.

In other words, cash today is backed up by no more than a solemn promise that it is legal tender within its issuing government’s sovereign jurisdiction.

QE does not involve actually printing physical banknotes, but instead “virtual cash” is created by the central bank making electronic transfers of newly created funds to the sellers of the debt securities being purchased under the QE programme.

Quite literally, QE money appears out of thin air, or at least cyberspace.

Strictly speaking, the debt securities bought with QE electronic cash must be sovereign bonds originally issued by a central bank’s own government treasury.

An indirect money-go-round occurs whereby the government Treasury sells its newly issued bonds to the marketplace in return for receiving existing “old” cash to pay for them, and then the buyers of these bonds then onsell them to the government’s central bank, which issues brand new cash as payment.

As a result of the government printing bonds and printing money more-or-less simultaneously, the central bank ends up owning its own government’s Treasury debt, with a net increase in cash circulating in the economy as a consequence.

A variant of QE is credit easing (CE) in which other kinds of debt securities are bought by the central bank, such as bonds issued by the government’s agencies, entities the government guarantees debts for, and even corporate bonds issued by the private sector that the government has nothing to do with.

The effect of the central bank buying up these various types of debt securities is to remove bonds from the marketplace and replace them instead with newly minted cash.

This extra cash is supposed to be recycled into the economy, stimulating demand, and thus production and consumption, at least in theory.

Another important, indeed critical, QE effect is “portfolio substitution”, in which the new cash issued by the central bank to hoover up bonds is deployed by the recipients to buy other, riskier, higher-yielding assets, such as corporate bonds and shares.

This portfolio substitution effect is the consequence of the peculiar circumstances under which QE is used of which more below.

The secret is zero interest rates

QE is classified as an “extraordinary” monetary policy, as it is imposed only after overnight cash interest rates controlled by the central bank have been driven down to at or near zero percent per annum, at which point these overnight rates have reached “effective lower bound” (ELB).

ELB is itself deemed to be an extraordinary monetary policy, as normally a central bank would never drop its official cash rate to zero.

The reason for avoiding ELB if at all possible is that the official cash rate is a nominal interest rate (ie., not adjusted for inflation) and cannot become negative as otherwise it would operate as a de facto tax on cash deposits.

Once ELB is reached, a central bank cannot additionally stimulate the economy it oversees with any further cash interest rate cuts.

If ELB doesn’t stimulate the economy, only then will the central bank consider proceeding to QE, as otherwise “printing money” - even if electronically – would cause inflation to take off.

The initial impact of QE is to lower longer-term interest rates and thereby the yields earned on bonds through the demand pressure exerted by the central bank as a massive purchaser of debt securities.

In a QE economy, not only are overnight cash interests rates at ELB, but longer-dated bonds yields fall to very low levels not far off zero as well.

Cheap credit

Money becomes cheap to borrow right across the term spectrum – assuming anyone wants to lend it – and supposedly the economy can pick itself up off the floor and get moving again on the basis of extension of artificially low cost credit.

Accordingly, QE is a type of shock therapy for an economy that is in serious trouble, and when economies have gotten into such bad shape, ordinarily there would be an associated bear market in corporate bonds and shares, because firms would be expected to suffer in such an unfavourable business environment.

In part two next week, Michael will explain portfolio substitution and the broader implications of further QE.

*Michael Coote is a freelance financial journalist whose publication list includes, the National Business Review, New Zealand Investor, The Press, and the New Zealand Centre for Political Research.

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To suggest the rort can go on forever is to ignore the market reaction which has to be to exchange shite cash for stuff like property and land. ie you get inflated values in areas that do not create employment from investment. Who would be stupid enough to invest capital into such a systemic fraud.!

Michael - thank you.
Wolly - quite right.
This is what Martenson was showing in that graph - the divergence between fiat issuance and the real world, and it's why I started commenting here. It cannot go on, creating money simply doesn't create stuff, and there would have to have been an infinite amount of stuff very quickly, when the graph went vertical.
One other comment - the Fed isn't the Govt, it's private (last I heard).

One other comment - the Fed isn't the Govt, it's private (last I heard).
The Board of Governors of the Federal Reserve System is a federal gov­ernment agency. The Board is composed of seven members, who are appointed by the President of the United States and confirmed by the U.S. Senate. Read More

Yes you are right but, that applies only to the 12 District Federal Reserve Banks which have absolutely no authority to impose anything upon anybody because of their private status.  As I said read more.

The FED is owned by Massey-Ferguson.
(scroll right down to the bottom and read the right hand colunm on the last table.)

At some point there will be a "disconnect"....  An "unmooring of Inflation".. ( as the FED puts it.)
This is a Central Banks worst nightmare... where the Market "sees" and responds to the illusionary and prosperity destroying game that money printing is..... 
At that point they will be totally trapped...  Unable to respond to deflationary risks and reluctant to smash inflationary expectations in the face of a chronically unhealthy Global Economy.
Until then... when push comes to shove.....ALL Central banks will continue providing liquidity... ( money printing )..
Just my view......
Cheers  Roelof

This isn't a rort and isn't "Money printing" in the traditional sense (i.e. Weimar republic - Germany and Zimbabwe Government style).
The US economy was in a deep recession with the banking system essentially in a liquidity trap. In such an envionment QE staves off deflationary pressures by freeing up liquidity in the system.
People (namely the republicans) in their fits of hysteria have screamed that the QE programmes will bring about unprecedented hyper-inflation in the US, however all of the evidence to date shows the contrary.


This isn't a rort and isn't "Money printing" in the traditional sense (i.e. Weimar republic - Germany and Zimbabwe Government style).
A more in depth analysis of your contentious  proposition is called for. 
Printing money by adding to the existing stock without the creation of effort being recorded on behalf of the new money automatically dilutes the savings of those who extended their effort in the past for future consumption.
And just because the Fed reserved the leverage of the QE largesse to the Primary Dealer banks does not alter the previous statement. They have quite corruptly engineered bubbles in various markets using these monies locked away from citizen use for money making purposes at the general tax payers expense.

Whilst your assumption is technically correct it is only one single variable in a complex system.
It might be more useful to state that if all other things remain constant and equal - then "Printing money by adding to the existing stock etc..."

Ralph - please feel free to explain the interaction of the other variables -  I am sure there are willing readers wishing to learn more about what is, as you say, a complex system. 

stephen said..."Printing money by adding to the existing stock without the creation of effort being recorded on behalf of the new money automatically dilutes the savings of those who extended their effort in the past for future consumption."
It is not just savers...  All the productivity gains that get made end up getting appropriated by the financial sector...  It is the F.I.R.E  economy that feasts on the growth of money supply.
If money supply was a constant.. ( ie. fixed amount )...  we would have benign deflation.
Productivity gains would lead to lower prices...  We would have to create lower denominations of currency.
peoples standard of living would increase.
There would be an aversion to debt....  Debt would only used for the most productive of ventures.
The distortions that are created by credit creation would dissappear.
The ONLY people that benefit from money supply growth are the ones who get first grasp at using the new money... ( Banks and the Banks preferential Borrowers).. the financial economy.
The financial economy adds NOTHING to increased prosperity, standards of living or productivity gains.
Cheers  Roelof


"The financial economy adds NOTHING to increased prosperity, standards of living or productivity gains."
Wars have been won and lost, at least in a significant part, because of the relative strength or weakness of a given player financial economy.  I think it would be near sighted to forget that.

Ralph... R u sure about that.???  I would have thought it was based on the productive capacity of a nation..???
AND sure....  when it comes to an event like a war..  I do understand and accept the reasons for a GOVT. may print money.

War is, above all else an economic activity.
Another example then, the strength and flexibility of the British financial system was a major reason why they created the largest empire (by population and land mass) the world has ever seen.
Even in the colonies they doubled life expectancy and halved child mortality rates - a direct improvement in standard of living.

I suspect that might be beyond the scope of this humble blog.  My point was simply that just because money is being printed isn't a reason for panic (by itself).
Governments have printed money for a long time now and hyperinflation is a rare outcome.

My point does not detract from the fact that watering the wine is just that. And by tricky management the Fed & ECB have precluded the population from spending the money into the system, hence avoiding immediate inflation. But as I have noted before not for the things we need. Selective monetary intermediation should surely have the stamp of voter approval not apparatchik decree.   

Agreed, watered down wine is an invention of the devil.
However, ask yourself:

  • How much money has the Fed created since 2007?
  • Has any government who didn't enter hyperinflation ever 'printed' such a sum before?
  • How is it there is only modest inflation in the last four years?

Clearly there is more to it than meets the eye.

"Clearly there is more to it than meets the eye."
Ralph... part of that is that the CPI does not actually measure the effects of the manifestation of increases in money supply.
The CPI is only an expression of a convoluted way of measuring some price changes..
Particularly in the USA... they make some wierd assumptions ( in my view) in massaging these price end up with the CPI.
So... to say there is only modest inflation... is debatable  ( in USA)

Correct, & how manipulated is NZ data?
The price of my filled roll just increased by 14%.  I guess that'll show up in the next qtrs data though.

Nah. Don't think the 14% will show up
There is some chicken entrail stuff that goes vaguely like this
Price of filled roll up by 14%
Punters will substitute so they can eat something as filling but at same or lower price. Could substitute with Fried Carrots or similar
Ergo, no (or very little) inflation.
Easy Peasy.
Another alternative is that Filled Rolls don't fall into the items that get measured for "Core inflation".  Ergo, no (or very little) inflation as, Hurrah!, they don't get measured.  Much like House Price increases don't get measured when calculating "core inflation"
While the water has been heating at a rate that the frog has noticed (as in recognizing that the price of the filled roll is up 14%), the mental anguish is cooled by seeing a CPI figure of much less than 14%.  Say, about 0.5% for the quarter?

MO - this is a real world. Money is a man-made construct. Said construct was constructed to fit the up-side of a gaussian. Unsurprisingly. Doesn't fit over the top, and is going to be ugly on the downside.
The reason there has been no effect on 'the economy' is that money can't conjure up 'stuff'.

Charles Crawford
One of the greatest passages in the Bible:

Then the Lord said to Cain, "Where is your brother Abel?""I know not," he replied. "Am I my brother's keeper?"

When - and to what extent - is X responsible for Y?
What is money, after all, but an expression of moral value, above all an expression of confidence about trust and integrity? Not merely now, but based on hard-won reputation for reliability in preceding generations, and echoing down the decades still to come 

Who wants to be paid in North Korean or Zimbabwean or Cuban currency? No-one. 

Why? Because that currency is an expression of cruelty, inefficiency, waste and stupidity. It is literally worthless for most practical purposes.

"Not an ocean of tears nor all the guns in the world can transform those pieces of paper in your wallet into the bread you will need to survive tomorrow. 

Those pieces of paper, which should have been gold, are a token of honor -- your claim upon the energy of the men who produce. 

Your wallet is your statement of hope that somewhere in the world around you there are men who will not default on that moral principle which is the root of money."

The Reserve Dollar is being debased by money printing.
I believe the following communique is in order.
John Cleese's Letter to America
To the citizens of the United States of America:
    In light of your failure to elect a competent President of the USA and thus to govern yourselves, we hereby give notice of the revocation of your independence, effective immediately.
    Her Sovereign Majesty, Queen Elizabeth II, will resume monarchical duties over all states, commonwealths and other territories (except Kansas, which she does not fancy).
    Your new prime minister, Tony Blair, will appoint a governor for America without the need for further elections. Congress and the Senate will be disbanded. A questionnaire may be circulated next year to determine whether any of you noticed.

There was a long thread on here a few weeks ago in response to a piece Bernard wrote principally about QE and the housing shortage.
In the light of Michael Cootes dissertation I wonder what the learned participants here think would happen if the following occurred here.
Housing NZ issued say 2 Billion Dollars in twenty year bonds at 0% coupon and the Reserve Bank bought them. 
Housing NZ then used the 2 Billion to build new rental housing stock in places and confugurations that fit their demand . If they concentrated on fairly high density two and three bedroom units that might represent 15,000 units if they got their design right and got some economies of scale working.
It would seem to me you would get the following effects.
1) Lots of employment thus lower expenses on Unemployment and more PAYE and GST revenue.
2) Less rental demand therefore lower rents.
3) Less demand for existing houses and more supply, especially if HNZ sold some of their more valuable properties and relocated tenants into more suitable new housing, therefore lower house prices.
4) maybe lower health costs if tenants were in better accommodation
5) savings in the dreaded accomodation supplement if then units were rented at say $150/week.
6) Rental income at $150/ week/unit would be over $100 mill per annum allowing for some other expenses which would enable HNZ to repay the Reserve Bank.
This would seem to be deflationary in respect of housing costs anyway, expansionary for the economy and actually reduce Government expenditure. It does rely on a bit of money printing.
Why would this not be good policy?

As much as I don't like money creation...  Your idea is preferred to the banks being the ones that create credit.
One unintended consequence of your idea is that we could have high building cost inflation,
BUT... your idea is better than ANYTHING the current GOVT has come up with.
the looming housing shortage has been pending for a while...  BUT the Govt has done nothing.

Michael, thanx for a great piece and i look forward to part 2.
Of course the word "inflation" is used to hide the realality of what is really happening which is the degradation of money.
On January 2 1959 the DOW was 587.59 and today it is about 13,000. That is, it has multiplied its self 22 12 times in that period.
Great, you may say, "My shares are now worth 22.12 times more than when i bought them"
But consider this
At the same time , 1959, the minimum wage in New Zealand was 9 pound 7 shillings and sixpence ($18.75) per week, and today is about $13 per hour. That is, it has increased by 26.94 times.
WHAT!. you say, even though wages in NZ have been screwed they have still outperformed the DOW.   "YES"
If you look hard at the DOW it just about only keeps up with inflation. So it is a good measure of inflation over time, but it IS NOT an investment, either long or short term.
Warren Buffet was quoted once as saying "I don't buy shares, i buy companies. Shares are for selling companies that you don't want"
The NZ and Australian super funds should be made to unite into one great big fund and buy companies. Just like the Canadian super fund tried to buy Auckland airport.