## Monday, August 9, 2010

### "Quantitative Easing"---Incentives to banks to start lending...My explanation with graphs!

This is a follow up to my last post regarding the Federal Reserves possible use of "quantitative easing" as a way of stimulating the economy by increasing the money supply.  In a nutshell, The Fed is going to create an account and deposit money into it.  Well, not money as we know it,  but electronic credits.  However,  it amounts to printing money out of thin air (although The Fed does not actually print money...that is another lesson).  They are going to use that "money" to buy various financial assets.  The term financial asset is rather broad, but in the short term The Fed is going to purchase (1) non-performing assets on banks balance sheets, which a fancy way of saying their bad loans and (2) buying short term US Treasury's, which is a fancy way of saying US government debt.  Specifically, I will focus on US Treasuries for the purposes of this lesson.
Lets use an easy example.  Assume Congress needs \$9,000 to finance some spending they want to do.  To get this \$9,000 they are going to sell 100 US Treasury Securities with a face value of \$100 for \$90 each. They sell them for \$90 with the promise to pay \$100 at some pre-determined time in the future, so the owner of the security will make \$10.  The supply and demand graph below illustrates this arbitrary equilibrium price I set. Notice the supply curve "S*B/T" is vertical at 100 bonds/treasuries. We will assume this is all there is in the market and no matter what the price, there are no more to be had (keeping it simple).

We know we make \$10 from this security, but to get a more accurate measure of our investment we want to convert this into a percent.  Calculating this percent, also known as Rate of Return OR Interest Rate, is important because you can use it to compare across investments (compare Treasury returns to stocks, other bonds, commodities, real estate, etc). To calculate our interest rate we take our investment (\$90) and divide it INTO our expected gain (\$10) then multiple by 100 to put it in percentage terms.  We find in this example our interest rate is 11.11%.  What a terrific interest rate, yes??
What The Federal Reserve is finding out is that the banks like this too! Banks are borrowing money from the Fed at almost a 0% interest rate (aka "Federal Funds Rate), and instead of lending it out to consumers and businesses, like The Fed desires them to, the banks are putting the money in US Treasuries, or government debt. They are doing this because (1) banks are hesitant to make loans in an uncertain economic climate, (2) in this economic climate earning 2% on an investment GUARANTEED by the US government (borrowing at 0% and putting in Treasuries earning 2% is better than a sharp stick in the eye) is a very safe strategy.
Since being foiled by the dastardly bankers, The Fed is pondering "quantitative easing", which means they are going to intervene in the Treasury market themselves! This is SIGNIFICANT, because it is somewhat a "last straw" measure to get banks lending.
Review the first paragraph of this entry because I want to pick up from there.  The Federal Reserve wants to make Treasuries unattractive to banks and to provide them an incentive to loan out money instead of socking it away in Treasuries.  The way to do that is for The Fed to BUY Treasury's themselves which will serve to DECREASE the interest rates those Treasuries earn!  Say what?
The Fed enters the market as a DEMANDER for US Treasury's.  As a new entrant with big bucks, they are going to INCREASE the demand for Treasuries.  See the graph below that illustrates this INCREASE in demand.

As happens when the demand for anything goes up relative to the supply, the price will INCREASE. The price of a \$100 Treasury increased from \$90 to \$95.  What happens to our  rate of return or interest rate? We earn  \$5 on the Treasury we bought for \$95.  Using our formula, the new interest rate is 5.26%, considerably less than before!  KEY POINT: There is an INVERSE relationship between the price of a Tresury Security (or Bond) and the interest rate it earns.  As the price increases the interest rate decreases. The reverse is true also: as the price of Treasury (Bond) decreases, the interest rate increases.
With this lower interest rate, the banks MAY consider other investment strategies, like, oh, I dont know, LENDING money to people to buy houses, cars, big screen TV's or to businesses to replace capital goods, buy new capital goods, expand factory production, or build new facilities?
The bottomline with employing quantitative easing is that lowering the Federal Funds Rate to virtually 0% has not loosened up the credit markets enough to spur sufficient economic activity (buying stuff).  If The Fed can make alternative, albeit safe investments, LESS attractive to banks, AND if they can relieve banks of non-performing loans so banks can loan out that money as well, then perhaps we can move forward.  It is risky and smacks of a last ditch effort...We will see how it works out!!!

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