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Understanding the Fed's "Money Printer" (QE, the Stock Market, and Inflation) - YouTube
Channel: Ben Felix
[0]
- Hey, everyone.
[1]
It feels good to be back with a new video
[2]
after taking a bit of
a break from YouTube.
[5]
Before getting to the video,
[6]
I just wanted to take a couple of seconds
[8]
to say thank you to all of you
for supporting the channel.
[11]
This came in from YouTube last week,
[13]
which was pretty cool for me,
[15]
and obviously the growth of the channel
[16]
would not be possible
without all of your support.
[19]
So again, thank you,
[20]
and I hope that you enjoy this video.
[22]
Stock markets swiftly recovered
[24]
from the deep losses that they experienced
[26]
when the COVID-19 pandemic began.
[29]
Good news, right?
[30]
Unless all of this is an illusion
[32]
caused by the Federal Reserve
printing huge piles of money.
[36]
If asset prices reflect
expectations about the future,
[40]
the market rising should
be viewed with optimism.
[43]
But there might be less optimism,
[45]
and there may even be pessimism
[47]
about a market that is being
artificially propped up
[49]
up by a central bank.
[51]
What if the central bank
can't print any more money
[53]
and stock prices drop?
[55]
And how can all of this
money printing be good
[57]
for the country's currency?
[60]
I'm Ben Felix, Portfolio
Manager at PWL Capital.
[63]
In this episode of
"Common Sense Investing,"
[65]
I'm going to tell you
what's really happening
[67]
when you hear that the
Fed is printing money.
[70]
(upbeat music)
[72]
Central bank actions are an
inherently political topic.
[76]
The information in this video
does not aim to take a side
[79]
on the level of involvement
[80]
that central banks should
have in the economy.
[83]
Rather, it aims to explain the mechanics
[85]
of some of the policy tools
that central banks use
[88]
and their potential impact on currencies
[91]
and financial markets.
[92]
You've probably heard that
the US Federal Reserve,
[95]
the central bank of the
world's largest economy,
[98]
is printing money.
[100]
Lots and lots of money.
[102]
You may have also heard
that the money printing
[104]
is the reason that the stock
market has recovered so quickly
[107]
from the recent downturn,
[109]
despite continued economic concerns.
[112]
To understand what money printing means
[114]
and how it might be related
to the stock market,
[116]
we first need to understand what money is.
[120]
Money is important to any
functioning capitalist economy.
[124]
It facilitates the exchange
of goods and services,
[127]
serves as the unit of account,
[128]
providing a standardized way
to measure income, wealth,
[132]
asset prices and profits
[134]
and act as a store of value,
[136]
allowing individuals and businesses
[138]
to store wealth in a convenient form.
[141]
When we are talking about money today,
[142]
we are talking about fiat money.
[145]
Fiat means "let it be" in Latin
[147]
and refers to money that
has no intrinsic value
[150]
but is used in an economy based
on government pronouncement.
[154]
Ultimately, the stability
[156]
of the fiat money used in an economy
[158]
comes from that economy's
productive capacity
[161]
and the state's endorsement
and protection of its use.
[164]
In other words, money
is a social construct
[167]
that facilitates economic activity.
[170]
The government does not
create most of the money
[172]
in the economy.
[174]
Governments are the only entity
[175]
that can print physical currency,
[177]
as in creating paper bills and coins.
[180]
But that's a small proportion
of the money in the economy.
[183]
Most of the money in the
economy comes from private banks
[186]
making loans to
individuals and businesses.
[189]
Every time that a new loan is issued,
[191]
it creates a loan, which
is an asset to the bank
[193]
and a liability to the customer,
[195]
and a deposit, which is
a liability to the bank
[197]
and an asset to the customer.
[200]
Money is electronically created
[201]
out of thin air, every
day by private banks.
[205]
Private banks are
competing with each other
[207]
to create money by issuing loans.
[209]
The primary constraint
that private banks face
[212]
is their ability to remain profitable.
[215]
They can't make too
many loans to borrowers
[217]
that will not be able to
eventually pay the loans back.
[220]
This constraint on
lending is very different
[223]
from the stereotypical
characterization of banking.
[227]
The ideas of fractional reserve banking
[230]
and the money multiplier effect,
[232]
where banks take in deposits
[233]
and then make loans based on
those deposits, are incorrect.
[238]
That's right, fractional reserve banking
[240]
is not how money works
in the modern economy.
[243]
In both Canada and the US,
[245]
private banks don't even
have reserve requirements.
[249]
As long as the bank believes
[250]
that they will make a profit on a loan,
[252]
they will make the loan,
[253]
creating new money out of thin air.
[256]
The practical implication of this reality
[258]
is that contrary to common belief,
[261]
borrowing is the money creating process
[263]
that allows for saving and
not the other way around.
[266]
As money moves around
within the banking system,
[270]
private banks need to keep an eye
[271]
on their net flows of money.
[274]
If a bank extends a loan to a customer
[276]
running a manufacturing business,
[277]
and the customer goes and buys equipment
[279]
from their supplier, who
uses a different bank,
[282]
the money leaves the customer's bank
[284]
and moves to the supplier's bank.
[286]
The money has not left the
private banking system,
[289]
but the customer's bank
has had a net negative flow
[292]
from the transaction.
[294]
Banks clear their net flows
[295]
through a central clearing house
[296]
at the end of each day,
[298]
using a special kind of
money called bank reserves.
[301]
If during a given day,
[303]
more money leaves the bank than comes in,
[305]
the bank owes the central clearing house.
[308]
The bank will cover that shortfall
[310]
by borrowing reserves in the
overnight lending market.
[313]
A bank with a net
positive flow for that day
[315]
might lend their excess money
[317]
to a bank with a net negative flow.
[319]
Deposits, while not required for lending,
[322]
are still important for banks
[324]
because it is cheaper to
pay interest on deposits
[327]
than it is to borrow in the
overnight lending market.
[330]
But deposits are not required for lending,
[332]
due to the existence of the
overnight lending market.
[335]
A bank will always make a loan
[337]
that they expect to be profitable,
[339]
knowing that they can borrow
to settle their net flows
[341]
in the overnight lending market.
[343]
The interest rate on
overnight loans between banks
[346]
is important to the economy.
[348]
If the overnight lending rate increases,
[350]
then banks need to charge
their customers more for loans
[353]
in order to remain profitable.
[355]
Central banks try to influence the rate
[357]
at which banks lend to each other
[359]
by supplying or removing liquidity
[361]
from the overnight lending market.
[363]
In some extreme cases, like
the financial crisis in 2008,
[367]
banks have trouble
settling their net flows
[369]
in the overnight lending market.
[371]
This is where the central bank
becomes an important backstop
[374]
to the banking system.
[376]
Instead of allowing the overnight
lending rate to skyrocket,
[380]
due to a lack of liquidity,
[381]
central banks will create
a special kind of money,
[384]
called bank reserves,
[385]
out of thin air to provide
liquidity to private banks.
[389]
This is why central
banks are referred to as,
[391]
"The lender of last resort."
[393]
As the bank of banks,
[395]
central banks are responsible
for executing monetary policy.
[400]
Monetary policy consists
of central bank actions
[403]
that are designed to
promote maximum employment,
[405]
stable prices and moderate
long-term interest rates.
[409]
Setting a target for the
overnight lending rate
[412]
is one of the ways that central banks
[414]
execute monetary policy.
[416]
By affecting the overnight lending rate,
[418]
central banks can, to an extent,
[420]
influence the demand for loans
from credit worthy borrowers
[423]
in the private banking system.
[425]
If interest rates are lower,
[427]
more people should be willing
and able to take out loans,
[430]
and the economy should be stimulated.
[432]
Raising the overnight rate
should have the opposite effect.
[436]
One of the ways that central banks
[438]
influence the overnight lending rate
[439]
is through open market operations.
[442]
Open market operations involve
[444]
the central bank transacting
with private banks
[447]
to add or remove the
supply of bank reserves
[449]
from the private banking system.
[451]
In order to decrease the
overnight lending rate,
[454]
the central bank would
create bank reserves
[456]
to purchase short-term
government securities
[458]
from the private bank.
[460]
An important note here
[461]
is that when the central
bank purchases securities
[464]
from the private bank,
[465]
the net effect
[466]
on the private banking system's
balance sheet is neutral.
[470]
After the transaction, the
central bank has a liability,
[473]
the bank reserves that they
created out of thin air
[475]
and an asset, the short-term
government security
[478]
that they purchased from the private bank.
[480]
The private bank
[481]
has sold some short-term
government securities
[483]
and gained bank reserves.
[485]
The net amount of their
financial assets has not changed.
[489]
In open market operations,
[491]
the central bank is not
literally printing currency.
[494]
They are creating bank reserves
[496]
and swapping them for
short-term government debt
[498]
in an effort to influence
short-term interest rates.
[501]
When the central bank
[502]
is purchasing large amounts of assets
[504]
from the private sector
[505]
in an effort to lower the
overnight lending rate,
[508]
the private banks may end up
[509]
with large positive settlement balances
[511]
at the end of the day.
[513]
When this happens,
[514]
the central bank will pay interest
[516]
on the positive balances.
[518]
In that sense, bank reserves
[519]
are really just another form
[521]
of short-term government debt.
[524]
Affecting the overnight lending rate
[526]
is known as a conventional
approach to monetary policy.
[530]
This conventional approach
[531]
starts to run into some problems
[533]
when the overnight lending rate
[534]
is already at or near zero,
[536]
like it is today.
[538]
This started happening in the US
[540]
during the 2008 financial crisis.
[542]
And it happened in Japan as early as 2001.
[545]
In both cases,
[546]
the solution was an unconventional
monetary policy tool,
[550]
known as quantitative easing or QE.
[553]
The execution of QE is nearly identical
[556]
to the open market
operations that are used
[559]
to influence short-term
interest rates every day,
[561]
with a few key differences.
[563]
QE involves buying much larger amounts
[566]
of longer maturity government bonds
[569]
and other private sector assets,
[570]
like corporate bonds and
asset-backed securities.
[574]
Remember, the activity
of creating bank reserves
[577]
out of thin air
[578]
to purchase short-term
government securities
[580]
from private banks is a routine activity
[583]
in executing monetary policy,
[585]
and private banks routinely
create money every single day.
[589]
But, despite its similarities,
[591]
it is quantitative easing
[593]
that gets associated with
the term "money printing."
[596]
Like other open market operations,
[598]
QE is an asset swap,
[600]
where the central bank
creates bank reserves,
[603]
the special money that banks use
[604]
in the overnight lending market,
[606]
and uses them to purchase
assets from private banks.
[610]
This asset swap
[611]
does not affect the private
sector's balance sheet,
[614]
but it does alter the composition
[616]
of the private sector's assets,
[618]
which is exactly what the
central bank is hoping for.
[621]
The intention of QE is to reduce
longer-term interest rates
[625]
to stimulate economic activity.
[627]
And there are several theories
[628]
about how it might be
able to accomplish that.
[630]
Portfolio balance theory suggests
[632]
that removing huge amounts
[634]
of long-term government bonds,
[636]
corporate bonds and
asset backed securities
[638]
from the open market
[639]
and sticking them on the
central bank's balance sheet
[641]
will increase the market price
[643]
of those types of securities
in the private sector,
[646]
reducing their yields.
[648]
This shift in the yield curve
[650]
could make a more favorable environment
[651]
for businesses and
individuals to borrow money,
[654]
kick-starting the economic engine.
[656]
Signaling theory suggests that
the central banks commitment
[660]
to buying huge amounts of assets
[662]
could signal their commitment
[663]
to continued accommodative
monetary policy in the future,
[667]
making people more comfortable
[668]
with borrowing and investing today.
[671]
Both of these theories
also inherently suggest
[673]
that QE should have a positive
impact on stock prices,
[677]
a more favorable environment for borrowing
[680]
and an expectation
[681]
of continued accommodative monetary policy
[684]
should mean less perceived risk
[686]
and a more favorable
outlook in the market.
[689]
Less risk and a better outlook
[690]
should mean higher asset
prices across the board,
[693]
including for stocks.
[695]
Empirically, there is evidence that QE
[697]
does impact stock prices positively.
[700]
In a 2014 paper, titled,
[702]
"Evaluating Asset- Market Effects
[704]
of Unconventional Monetary Policy:
[706]
A Cross-Country Comparison,"
[708]
the authors use an event
study analysis to show that
[711]
within their sample, a 25
basis point surprise reduction
[715]
in the 10-year US treasury yield
[717]
results in a 0.7%
increase in stock prices.
[721]
The authors also indicate
[723]
that unconventional monetary policy tools
[725]
become less impactful to equity prices
[727]
when short-term rates are
already at or close to zero,
[730]
like they are right now.
[732]
None of this should be
particularly surprising.
[734]
When a central bank executes
[736]
an accommodative monetary policy action
[738]
designed to stimulate the economy,
[740]
market participants expect
there to be a positive effect.
[744]
This expectation through various channels
[746]
is reflected in rising stock prices.
[749]
I think it's a bit of a stretch
[750]
to say that central
banks are single-handedly
[753]
propping up the stock market.
[755]
Monetary policy and expectations
[757]
about future monetary policy
[759]
are important inputs in
the asset pricing equation,
[762]
but there are many other inputs.
[763]
The bigger concern that many people have
[765]
when they hear about money printing
[767]
is the effect on inflation.
[770]
Inflation was a major concern
[771]
when the Federal Reserve
originally rolled out QE in 2008,
[775]
even prompting a group
of economists, professors
[777]
and fund managers to write an open letter
[780]
to then Chairman of the
Federal Reserve, Ben Bernanke,
[782]
voicing their inflationary concerns.
[785]
Let's remember what's going on here.
[787]
Banks are selling
long-term government bonds,
[789]
corporate bonds, and other
assets to the central bank
[792]
in exchange for bank reserves,
[794]
which are really just another form
[796]
of short-term government debt.
[798]
This is where the disconnect
[799]
between the image of money printing
[801]
and the reality of quantitative easing
[803]
becomes most evident.
[805]
Quantitative easing
results in the creation,
[807]
out of thin air, of bank reserves,
[810]
leaving the net financial assets
[811]
of the private sector unaffected.
[814]
The relationship between
increasing bank reserves
[816]
and private banks creating
money by lending to customers,
[819]
which could be inflationary,
does not exist.
[822]
This was examined in the US
[824]
in a 2010 finance and economics
[826]
discussion series working paper titled,
[829]
"Money, Reserves and the
Transmission of Monetary Policy:
[832]
Does the Money Multiplier Exist?"
[835]
The authors concluded that,
[836]
"Changes in reserves are unrelated
[838]
to changes in lending.
[840]
And open market operations
[841]
do not have a direct impact on lending.
[844]
We conclude that the
textbook treatment of money
[847]
in the transmission
mechanism can be rejected.
[850]
Specifically, our results indicate
[852]
that bank loan supply does
not respond to changes
[855]
in monetary policy through
a bank lending channel,
[859]
no matter how we group the banks."
[860]
The Bank of England,
similarly dispelled the idea
[863]
that lending is related to bank reserves.
[866]
in 2014 bulletin titled,
[867]
"Money Creation in the Modern Economy."
[870]
They explain,
[871]
"Reserves are an IOU from the Central Bank
[874]
to commercial banks.
[875]
Those banks can use them to
make payments to each other,
[878]
but they cannot lend them out
[880]
to consumers in the economy
[882]
who do not hold reserves accounts.
[884]
When banks make additional loans,
[886]
they are matched by extra deposits.
[889]
The amount of reserves does not change."
[891]
At a time when central banks
[893]
are using unconventional
monetary policy tools
[896]
to stimulate economic activity,
[898]
beyond what was possible
[899]
through conventional monetary policy,
[901]
deflation is likely to
be a bigger concern.
[904]
This has been the experience in Japan,
[907]
where we have the longest
running QE experiment.
[909]
Money is the medium that
facilitates economic activity.
[913]
Most of the money in the
economy comes from private banks
[916]
making loans to
individuals and businesses.
[919]
The demand for loans from
credit worthy borrowers
[922]
is what dictates the amount
of money in the economy.
[925]
Central banks attempt
to influence this demand
[927]
by raising or lowering
overnight lending rates.
[930]
But when that rate is already at zero,
[933]
they might use unconventional
monetary policy
[936]
to affect longer-term interest rates.
[938]
Unconventional monetary policy
should increase asset prices,
[942]
including stock prices,
[944]
but it's not sufficient to single-handedly
[946]
prop up the stock market.
[947]
Finally, the idea
[948]
that all of this so-called money printing
[950]
will lead to it inflation, is misguided.
[953]
Quantitative easing is an asset swap
[956]
that changes the composition
[957]
of private sector financial assets
[959]
without affecting the net amount
[961]
of private sector assets.
[963]
Further, private banks do
not lend out bank reserves
[966]
to their customers.
[967]
Money creation in the economy
[969]
comes from demand for loans
from credit worthy borrowers.
[973]
At a time when a central bank has decided
[975]
that unconventional monetary
policy is necessary,
[978]
that demand for loans must be low,
[981]
meaning that deflation is a
bigger concern for the economy.
[984]
Now that we've gone through the details
[986]
of how central banks
execute monetary policy
[988]
and the potential impact of their actions
[990]
on the economy and the financial markets,
[992]
there's one more important
point to consider.
[995]
In a 2013 paper, Eugene Fama,
[998]
the father of the efficient
market hypothesis,
[1000]
demonstrated that the Federal
Reserve's target interest rate
[1003]
does not appear to affect
long-term interest rates.
[1006]
And there is a substantial
amount of uncertainty
[1009]
about whether or not the fed
short-term interest rates.
[1013]
In other words, Fama's suggestion
[1015]
is that the Fed's actions may
have much less of an impact
[1018]
than many people believe them do.
[1020]
The stock market and inflation
are both unpredictable.
[1024]
Central bank actions are
only one of the many reasons
[1026]
that this is true, if they
have any impact at all.
[1029]
Fixating on the central bank's actions
[1031]
and allowing them to influence
your investment decisions
[1034]
would be a mistake.
[1035]
Long-term, only a cross
section of the companies
[1038]
around the world, through
low cost index funds
[1041]
is the most sensible approach
[1042]
to dealing with the unpredictable
nature of stock markets
[1045]
in the short term.
[1046]
If you want to learn
more about this topic,
[1048]
I highly recommend the books,
[1050]
"Pragmatic Capitalism," by Cullen Roche,
[1052]
and, "Economics for
Everyone," by Jim Stanford.
[1055]
Both of which give clear and accurate
[1057]
operational descriptions
[1059]
of the way that money works
[1060]
within a modern capitalist economy.
[1062]
Thanks for watching.
[1062]
My name is Ben Felix of PWL Capital,
[1064]
and this is, "Common Sense Investing."
[1067]
If you enjoyed this video,
please share it with someone
[1069]
that you think could benefit
from the information.
[1071]
And don't forget, if you've run out
[1073]
of "Common Sense
Investing" videos to watch,
[1075]
you can tune into weekly episodes
[1077]
of the "Rational Reminder" podcast
[1079]
wherever you get your podcasts.
[1080]
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