How Does QE Cause Equities to Rise ?

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Bustoff
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How Does QE Cause Equities to Rise ?

Post by Bustoff »

Does anyone know what the major banks do with the $85 billion per month they receive in QE stimulus ?
Or, same question phrased differently, how does the money injected into banks cause stock to rise.

We all understand that QE means the Fed purchases bonds from the major banks and pays for the bonds by crediting those major bank's reserve accounts with additional funds. This supposedly generates an expansion in the supply of central bank money.

But exactly how does that money, now in sitting the accounts of the major banks, make it into the equity market ?
Last edited by Bustoff on Fri Sep 20, 2013 7:54 am, edited 1 time in total.
richard
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Re: How Does QE Cause Equities to Rise ?

Post by richard »

One of the major things that cause equities to rise is expectations about the economy.

The Fed has a lot of power over the economy and QE can be thought as a signal of the Fed's intentions regarding the economy. The exact mechanics are a bit beside the point.
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Re: How Does QE Cause Equities to Rise ?

Post by lwfitzge »

purchase monetary assets from banks, expand monetary base, increasing the value of the assets and decrease their yields. This decrease interest rates, the cost of borrowing for companies and consumers and lowers their interest payments. Companies invest new capital invested in expansionary things that should create value and cash flow. Equity prices are a reflection of future cash flows (value) of a company.
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Bustoff
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Re: How Does QE Cause Equities to Rise ?

Post by Bustoff »

richard wrote:One of the major things that cause equities to rise is expectations about the economy.

The Fed has a lot of power over the economy and QE can be thought as a signal of the Fed's intentions regarding the economy. The exact mechanics are a bit beside the point.
Thanks Richard, but I'm not looking for theory.
The "exact mechanics" are exactly the point of my question.
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Re: How Does QE Cause Equities to Rise ?

Post by zed »

Bustoff wrote:
richard wrote:One of the major things that cause equities to rise is expectations about the economy.

The Fed has a lot of power over the economy and QE can be thought as a signal of the Fed's intentions regarding the economy. The exact mechanics are a bit beside the point.
Thanks Richard, but I'm not looking for theory.
The "exact mechanics" are exactly the point of my question.
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Bustoff
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Re: How Does QE Cause Equities to Rise ?

Post by Bustoff »

lwfitzge wrote:purchase monetary assets from banks, expand monetary base, increasing the value of the assets and decrease their yields.
That's the bond market.
lwfitzge wrote:This decrease interest rates, the cost of borrowing for companies
Those companies are not borrowing from the banks that recieve the QE stimulus, They issue their own corporate bonds and sell their own corporate bonds to raie money. So how does that increase equity prices ?
lwfitzge wrote:Companies invest new capital invested in expansionary things that should create value and cash flow.
That's theory.
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Re: How Does QE Cause Equities to Rise ?

Post by wriggly »

See http://en.wikipedia.org/wiki/Quantity_theory_of_money

QE is an attempt to increase the money supply in order to compensate for a drop in money velocity, while keeping inflation within "normal" limits. The more QE is applied, the greater the chance that it may overshoot, causing above-average inflation, which typically means higher prices for things (including equities).

Any increase in the probability of higher prices in the future leads to higher prices now.
Last edited by wriggly on Fri Sep 20, 2013 8:05 am, edited 1 time in total.
Tom_T
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Re: How Does QE Cause Equities to Rise ?

Post by Tom_T »

One of the reasons for QE is to drive investors into stocks by keeping interest rates low (and making bonds unattractive.) Supposedly, as corporations and wealthy people see their portfolios grow, they will be more willing to spend money, thereby helping the economy. That's the goal, anyway.
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Re: How Does QE Cause Equities to Rise ?

Post by FoolishJumper »

Much like Tom_T said, the purpose is to drive 'people' (being both individuals and other entities) out of bonds, which drives them into other investments.

The main basis (as thought up by the Japenese during their deflation days in the 90's) is:

Treasury/Central Bank makes money out of thin air (the ability to create money is critical here - so countries which have dollarizd [taking another countries currency as their own or at fixed exchange] could not QE or their inflation would go wild)
Central Bank buys government bonds from the banks with that money, thereby raising their prices and making them less attractive to investors
Those investors then take the money they got from their bonds (or new money they don't want to put in bonds) and either lend to individuals (in the case of banks) or invest in other businesses (in the case of insurance/pension funds)
Once the economy recovers, the bank sells those bonds again and 'destroys' the created money

The economy has therefore grown (and of course equity rises as per your original request), but there has been no long-term over-inflation as the supply of money hasn't increased. The risk is of course overshooting as Wriggly mentioned.

You are saying you don't want theory, but that is all there is to QE. The fact that equities has rised doesn't prove the theory. It's likely claiming lower taxes helps the overall economy is proven by the fact the economy grew after taxes dropped. The first rule of testing a hypothesis is only changing one parameter...which is of course impossible when it comes to the economy!
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Re: How Does QE Cause Equities to Rise ?

Post by Bustoff »

wriggly wrote:QE is an attempt to increase the money supply...

OK... I mentioned that in my OP ?
wriggly wrote:The more QE is applied, the greater the chance that it may overshoot, causing above-average inflation, which typically means higher prices for things (including equities).
There is no "above-average inflation".
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Re: How Does QE Cause Equities to Rise ?

Post by wriggly »

Bustoff wrote: There is no "above-average inflation".
See the line added to my previous post. Even without above-average inflation now, an increase in the probability in the future affects prices now.

Note, in the case of prices, it doesn't even matter whether a theory is true, just whether enough people believe it to be.

If I have a ticket to lunch with an anonymous author, and a number of people believe that the author is J.K.Rowling, I can sell the ticket for a much higher price, whether it is true or not.

So, the real non-theoretical mechanism is that a lot of people believe that QE will cause equity prices to rise, possibly for the reasons given above, and so they are willing to buy at higher prices (and unwilling to sell at the previous lower price).
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Bustoff
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Re: How Does QE Cause Equities to Rise ?

Post by Bustoff »

Tom_T wrote:One of the reasons for QE is to drive investors into stocks by keeping interest rates low (and making bonds unattractive.)
I'm not asking for the "reasons" we have QE, but rather where that money went that was injected into the major banks ?
Moreover, where have you been suggesting that bonds have not performed well since QE began. Did you miss what happened to interest rates since QE began ? Did you miss the fact that bonds rallied ?
Tom_T wrote:Supposedly, as corporations and wealthy people see their portfolios grow, they will be more willing to spend money, thereby helping the economy.
Corporations are more profitable not because they are selling more products. Quite the contrary, corporations are more proftable because they drastically reduced spending and made huge cuts in their work force. In other words they reduced costs.

So I'll ask again, does anyone "know" or can they point to a source that does know what the major banks do with the money recieved from the fed?
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Re: How Does QE Cause Equities to Rise ?

Post by YDNAL »

Bustoff wrote:Does anyone know what the major banks do with the $85 billion per month they receive in QE stimulus ?
Or, same question phrased differently, how does the money injected into banks cause stock to rise.
HERE is what PIMCO thinks.
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Re: How Does QE Cause Equities to Rise ?

Post by thx1138 »

Bustoff wrote: So I'll ask again, does anyone "know" or can they point to a source that does know what the major banks do with the money recieved from the fed?
What are "the major banks"? QE3 is purchasing MBS by the way...
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Re: How Does QE Cause Equities to Rise ?

Post by wriggly »

The reason you're having to ask twice is that your subject and paraphrased question both ask about the relationship between QE and equity prices. Note, the relationship is really between announcments that change expectations of future QE and current stock prices.

The question you really seem to want answered is how banks use the new money, which is a completely different question. That new money might not be affecting stock prices at all (see the above PIMCO link).
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Re: How Does QE Cause Equities to Rise ?

Post by JoMoney »

thx1138 wrote:
Bustoff wrote: So I'll ask again, does anyone "know" or can they point to a source that does know what the major banks do with the money recieved from the fed?
What are "the major banks"? QE3 is purchasing MBS by the way...
I don't think it works the way it's being described here. The money doesn't appear on the balance sheets of commercial banks, it goes to whoever is selling bonds (i.e. the U.S. Treasury, and government "agency backed" MBS (Freddie/Fannie). The Fed is buying the bonds using their "Open Market Operations" competing with whoever else would be buying government bonds. Since most bonds are in some form pegged to the risk-free treasury bonds, the rate for all bonds drops. After the Fed has bought the bonds, they add these to their central banks balance sheet as collateral for the money they created out of thin air. Any interest or money made on this is eventually given back to the Treasury, because the Fed is a government chartered group acting (somewhat) independently to control inflation while maximizing employment.

Since the Fed's buying government bonds is keeping rates low for all bonds, it makes it cheap for commercial banks to borrow short-term and lend long-term, and for businesses to borrow (or sell bonds) to grow their business. When they stop, it means interest rates are going to be set by a true supply and demand without there massive buying.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham
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Re: How Does QE Cause Equities to Rise ?

Post by Tom_T »

"But exactly how does that money, now in sitting the accounts of the major banks, make it into the equity market ? "

The problem is that your premise is wrong. The market is not up because QE money goes into the market.
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Re: How Does QE Cause Equities to Rise ?

Post by JoMoney »

It is making it very cheap for businesses to borrow money though. This gives businesses higher profit margins, which improves earnings, which may improve stock prices.
The goal is to get employment up. Under the premise that if businesses can expand cheaply, they will, and it will require more people to do so. It also gives lots of easy money to Congress to spend on government projects, also helping unemployment.
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Re: How Does QE Cause Equities to Rise ?

Post by richard »

Bustoff wrote:
richard wrote:One of the major things that cause equities to rise is expectations about the economy.

The Fed has a lot of power over the economy and QE can be thought as a signal of the Fed's intentions regarding the economy. The exact mechanics are a bit beside the point.
Thanks Richard, but I'm not looking for theory.
The "exact mechanics" are exactly the point of my question.
The exact mechanics are that QE works through the expectations channel. The market takes continuing QE as a sign that the Fed will be more accommodation than the market had expected.

Bernanke stressed the importance of forward guidance and expectations at his press conference.

Consider that the announcement of the continuation of an $85 billion purchase (rather than an expected tapering by $10 billion or so) resulted in hundreds of billions or trillions in increased asset values. A pure mechanical explanation would require a huge and implausible multiplier for something on the order of an additional $10 billion to have such a large effect.

Google qe expectations channel for more, as well as competing theories. For example, here's a St Louis Fed paper listing the expectations channel and the portfolio balance channel as the leading theories, http://www.stlouisfed.org/publications/ ... s/?id=2258 and here's a subsequent paper to the effect the portfolio balance channel explanation is not valid. http://research.stlouisfed.org/wp/2012/2012-015.pdf
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Re: How Does QE Cause Equities to Rise ?

Post by dmcmahon »

You might find this piece by John Hussman of interest re. QE and security prices:

http://www.hussmanfunds.com/wmc/wmc110307.htm

All securities have to be held by someone. This is why on this board people often groan when they hear that money is "flowing out of" [bonds/stocks/whatever]. Hussman's thesis: if the supply of bonds is reduced, and their yields suppressed, then they look less attractive to investors, who will, as a group, be willing to bid up other assets that have become relatively more attractive. Hussman isn't saying that the QE actually made the other assets attractive, mind you - he's saying that the equilibrium point versus now-unattractive bonds is shifted.
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Re: How Does QE Cause Equities to Rise ?

Post by Optimistic »

Bustoff wrote:But exactly how does that money, now in sitting the accounts of the major banks, make it into the equity market ?
It doesn't necessarily. Suppose today BigPharma Corp's stock price is $10 and they have 1 billion shares outstanding. In a couple of hours they announce they've developed the best drug ever that will cure many diseases. It will be a few years before they can profit from it, but investors holding the stock will now be unwilling to sell at $10. Suppose instead the market price for the stock has jumped to $50. The value of the company's public stock has increased from $10 billion to $50 billion. However, that does not indicate that $40 billion dollars "made it into the equity market". Likewise, QE affects investors expectations for the market. Even if a single dollar from QE is never used to purchase a stock, the value (cost) of the stock market has risen because investors have a higher demand for it as a result of QE.
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Re: How Does QE Cause Equities to Rise ?

Post by manwithnoname »

JoMoney wrote:
thx1138 wrote:
Bustoff wrote: So I'll ask again, does anyone "know" or can they point to a source that does know what the major banks do with the money recieved from the fed?
What are "the major banks"? QE3 is purchasing MBS by the way...
I don't think it works the way it's being described here. The money doesn't appear on the balance sheets of commercial banks, it goes to whoever is selling bonds (i.e. the U.S. Treasury, and government "agency backed" MBS (Freddie/Fannie). The Fed is buying the bonds using their "Open Market Operations" competing with whoever else would be buying government bonds. Since most bonds are in some form pegged to the risk-free treasury bonds, the rate for all bonds drops. After the Fed has bought the bonds, they add these to their central banks balance sheet as collateral for the money they created out of thin air. Any interest or money made on this is eventually given back to the Treasury, because the Fed is a government chartered group acting (somewhat) independently to control inflation while maximizing employment.

Since the Fed's buying government bonds is keeping rates low for all bonds, it makes it cheap for commercial banks to borrow short-term and lend long-term, and for businesses to borrow (or sell bonds) to grow their business. When they stop, it means interest rates are going to be set by a true supply and demand without there massive buying.
Not exactly. According to a bond trader I spoke to, the fed decides to call Treasuries by exchanging a class of treasury bonds in the account of a primary dealer (one of the 26 or so largest banks) and gives the bank an equal amount of cash to be used for loans, investments, etc. Bank looks for ways to invest the funds in accordance with the rules of the many agencies that have over sight of banks: SEC, CFTC, office of the controller of the currency, mortgage regulators, FDIC, etc. There are rumors that some of this money found its way to foreign investors such as Chinese trust co that were financing commodities speculators. Fed also buys mortgage backed securities of about $40B per months from banks. Fed collects interest on T bonds it exchanges from banks and pays 75% of the interest to the Treasury which pays for gov. operations. In 2012 Fed returned about $90B to treasury.
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Re: How Does QE Cause Equities to Rise ?

Post by Bustoff »

At the risk of blurring the issue let me ask the following:
In order for the Fed to buy $85 billion of bonds per month from their primary dealers (Morgan Stanley, JP Morgan, et al) those primary dealers have to possess those bonds in order to sell them. We can infer that those primary dealers come into possession of those bonds by purchasing them.
When the primary dealers purchase all those bonds,those purchases in turn support the bond market. But according to the popular theory, QE drives rates down causing investors to flee bonds in favor of stocks. This begs the question, why would anyone sell bonds when prices are rising ? QE has extended the rally in bonds, not driven investors away from bonds. Thus, the effect seems to be that QE is directly helping the bond market more than the stock market.
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Re: How Does QE Cause Equities to Rise ?

Post by Valuethinker »

Bustoff wrote:At the risk of blurring the issue let me ask the following:
In order for the Fed to buy $85 billion of bonds per month from their primary dealers (Morgan Stanley, JP Morgan, et al) those primary dealers have to possess those bonds in order to sell them. We can infer that those primary dealers come into possession of those bonds by purchasing them.
When the primary dealers purchase all those bonds,those purchases in turn support the bond market. But according to the popular theory, QE drives rates down causing investors to flee bonds in favor of stocks. This begs the question, why would anyone sell bonds when prices are rising ? QE has extended the rally in bonds, not driven investors away from bonds. Thus, the effect seems to be that QE is directly helping the bond market more than the stock market.
We cannot make such definitive assertions. It's not mechanical like that.

If we increase the demand for bonds, for the same supply, the price rises (yield falls). That rising price brings out new sellers-- amount bought and amount sold is always equal. There is always someone who will sell a bond for a given price-- otherwise the price would rise to infinity with demand not being met.

Lower bond yields are good for stock prices because of opportunity cost. If bonds pay lower yields, then investors seeking higher returns chase riskier assets, particularly stocks. The cost of investing in stocks, in terms of forgone bond interest, is lower.

The big thing with QE is that it has driven interest rates down: corporate loans and bonds are priced as a yield spread on safe Treasury Bonds of the same maturity. Drive down Treasury yields tends to drive down the yields on corporate bonds and interest rates on corporate loans (the financial intermediaries could open up a wider spread, ie make more profit, but if they make more profits that means banks have more capital, which they tend to lend).

Also the purchase of government guaranteed MBS has driven down the forward yield curve, and hence the pricing of new mortgages. That's another direct link into the real economy-- lower mortgage rates is both good for new buyers and for refinancings, which put more spending power into the pockets of homeowners.

The other channel for real effects of QE is to drive down the USD, which increases exports/ import substitution. It may also increase expectations of inflation, and that's key, because it means companies and individuals will bring forward investment plans (why keep money in the bank at 0% when you are facing 4% inflation on things that you want).

I have seen that here in the UK (big QE). I am getting 0% on my bank account, and construction costs are still rising 3-5% pa (in fact they have spiked I would reckon at the moment +10%). It makes sense to do the home improvements *now*.
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Re: How Does QE Cause Equities to Rise ?

Post by MathWizard »

Bustoff wrote:
richard wrote:One of the major things that cause equities to rise is expectations about the economy.

The Fed has a lot of power over the economy and QE can be thought as a signal of the Fed's intentions regarding the economy. The exact mechanics are a bit beside the point.
Thanks Richard, but I'm not looking for theory.
The "exact mechanics" are exactly the point of my question.
There are no exact mechanics.

There is no formula that sets prices of stocks. The price is set by
what the last willing seller sold at the last willing buyer would pay.

So there are a bunch of people on the ask side and a bunch of people on the bid side.
When the lowest ask hits the highest bid price that sets the price.

That is the mechanics of pricing.

If I knew the mechanics of how people price the way they do, I would be on a large yacht off the coast of France.
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Re: How Does QE Cause Equities to Rise ?

Post by ogd »

Bustoff wrote:When the primary dealers purchase all those bonds,those purchases in turn support the bond market. But according to the popular theory, QE drives rates down causing investors to flee bonds in favor of stocks.
It might be a popular theory, but the mechanism is nowhere near as simple. What QE is designed to do is to lower the cost of credit (corporate bonds and mortgages in particular; witness all the bond issuance and the homebuying / refi activity), by removing yield alternatives from the market. This in turn spurs economic activity. It's the same reason why central banks lower interest rates to stimulate a depressed economy ("easing"), except that when the interest rates are zero that can't work anymore, so credit must be made cheaper through other means ("quantitative").
Bustoff wrote:This begs the question, why would anyone sell bonds when prices are rising ?
Rational investors, of course, seeing how their forward return prospects are getting lower and lower. But it is actually a very good question in that it highlights a problem with the "popular theory" -- money was going into the bond market throughout the low interest rate period, so it wasn't bond outflows that powered the stock market, but simply the belief that the economy does better when credit is cheaper ("better" is relative, of course, ideally this wouldn't be needed but that's where we are).
Last edited by ogd on Fri Sep 20, 2013 12:55 pm, edited 1 time in total.
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Re: How Does QE Cause Equities to Rise ?

Post by swaption »

Bustoff wrote:At the risk of blurring the issue let me ask the following:
In order for the Fed to buy $85 billion of bonds per month from their primary dealers (Morgan Stanley, JP Morgan, et al) those primary dealers have to possess those bonds in order to sell them. We can infer that those primary dealers come into possession of those bonds by purchasing them.
When the primary dealers purchase all those bonds,those purchases in turn support the bond market. But according to the popular theory, QE drives rates down causing investors to flee bonds in favor of stocks. This begs the question, why would anyone sell bonds when prices are rising ? QE has extended the rally in bonds, not driven investors away from bonds. Thus, the effect seems to be that QE is directly helping the bond market more than the stock market.
Will try and keep this simple. The primary dealers never own the bonds, they just distribute. The proceeds go directly to the issuer. Putting aside consideration of money supply which gets a bit more complex, the end result is not all that diffferent than whay you might see when any big buyer is trying to corner the market in anything, essentially the price goes up. In this case, bond prices go up and it crowds out other investors. The first implication of rising prices is that interest rates go down and financing cost for just about everything else goes down and this boosts econcomic activity. But further, that $85 billion that that other investors are not using to buy treasuries and mbs needs to go somewhere, so demand increases for everything (i.e. if someone tries to corner the market for BMW's, that would be good for Mercedes). The most logical beneficiary is other fixed income (corporate bonds, etc.), but really any asset. But the further benefit of lower rates is that it drives people to take risk in order to get yield and this helps risky assets like high yield bonds and equities.
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Re: How Does QE Cause Equities to Rise ?

Post by manwithnoname »

Bustoff wrote:At the risk of blurring the issue let me ask the following:
In order for the Fed to buy $85 billion of bonds per month from their primary dealers (Morgan Stanley, JP Morgan, et al) those primary dealers have to possess those bonds in order to sell them. We can infer that those primary dealers come into possession of those bonds by purchasing them.
When the primary dealers purchase all those bonds,those purchases in turn support the bond market. But according to the popular theory, QE drives rates down causing investors to flee bonds in favor of stocks. This begs the question, why would anyone sell bonds when prices are rising ? QE has extended the rally in bonds, not driven investors away from bonds. Thus, the effect seems to be that QE is directly helping the bond market more than the stock market.

Primary dealers come into possession of T securities because under the rules a Primary dealer is required bid on each issue of treasury securities and the Treasury allocates a quota to each bank which can be sold to investors or retained by the bank. Primary dealers do not have a choice of receiving $M in place of T securities. The fed simply exchanges a series of T bonds in the banks inventory of assets with cash. Banks are supposed to use the funds for loans or investments such as new issue of treasury bonds.
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Re: How Does QE Cause Equities to Rise ?

Post by cflannagan »

Something like a butterfly wing flapping eventually causing a hurricane later on. Not directly because of each other, but a series of events.
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Re: How Does QE Cause Equities to Rise ?

Post by Tom_T »

Bustoff wrote:At the risk of blurring the issue let me ask the following:
In order for the Fed to buy $85 billion of bonds per month from their primary dealers (Morgan Stanley, JP Morgan, et al) those primary dealers have to possess those bonds in order to sell them. We can infer that those primary dealers come into possession of those bonds by purchasing them.
When the primary dealers purchase all those bonds,those purchases in turn support the bond market. But according to the popular theory, QE drives rates down causing investors to flee bonds in favor of stocks. This begs the question, why would anyone sell bonds when prices are rising ? QE has extended the rally in bonds, not driven investors away from bonds. Thus, the effect seems to be that QE is directly helping the bond market more than the stock market.
The three-year annual return on Total Bond Market is 2.31%. The three-year annual return on Total Stock Market is 18.81%. Which rally would you want to be a part of?
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Re: How Does QE Cause Equities to Rise ?

Post by grayfox »

swaption wrote:
Bustoff wrote:At the risk of blurring the issue let me ask the following:
In order for the Fed to buy $85 billion of bonds per month from their primary dealers (Morgan Stanley, JP Morgan, et al) those primary dealers have to possess those bonds in order to sell them. We can infer that those primary dealers come into possession of those bonds by purchasing them.
When the primary dealers purchase all those bonds,those purchases in turn support the bond market. But according to the popular theory, QE drives rates down causing investors to flee bonds in favor of stocks. This begs the question, why would anyone sell bonds when prices are rising ? QE has extended the rally in bonds, not driven investors away from bonds. Thus, the effect seems to be that QE is directly helping the bond market more than the stock market.
Will try and keep this simple. The primary dealers never own the bonds, they just distribute. The proceeds go directly to the issuer. Putting aside consideration of money supply which gets a bit more complex, the end result is not all that diffferent than whay you might see when any big buyer is trying to corner the market in anything, essentially the price goes up. In this case, bond prices go up and it crowds out other investors. The first implication of rising prices is that interest rates go down and financing cost for just about everything else goes down and this boosts econcomic activity. But further, that $85 billion that that other investors are not using to buy treasuries and mbs needs to go somewhere, so demand increases for everything (i.e. if someone tries to corner the market for BMW's, that would be good for Mercedes). The most logical beneficiary is other fixed income (corporate bonds, etc.), but really any asset. But the further benefit of lower rates is that it drives people to take risk in order to get yield and this helps risky assets like high yield bonds and equities.
:thumbsup This sounds like the best explanation so far. [I am not an expert. It just sounds the most logical.]
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Re: How Does QE Cause Equities to Rise ?

Post by manwithnoname »

Bustoff wrote:At the risk of blurring the issue let me ask the following:
In order for the Fed to buy $85 billion of bonds per month from their primary dealers (Morgan Stanley, JP Morgan, et al) those primary dealers have to possess those bonds in order to sell them. We can infer that those primary dealers come into possession of those bonds by purchasing them.
When the primary dealers purchase all those bonds,those purchases in turn support the bond market. But according to the popular theory, QE drives rates down causing investors to flee bonds in favor of stocks. This begs the question, why would anyone sell bonds when prices are rising ? QE has extended the rally in bonds, not driven investors away from bonds. Thus, the effect seems to be that QE is directly helping the bond market more than the stock market.
Primary dealers come into possession of T securities because under the rules a Primary dealer is required bid on each issue of treasury securities and the Treasury allocates a quota to each bank which can be sold to investors or retained by the bank. Primary dealers do not have a choice of receiving $M in place of T securities. The fed simply exchanges a series of T bonds in the banks inventory of assets with cash. Banks are supposed to use the funds for loans or investments such as new issue of treasury bonds.
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Re: How Does QE Cause Equities to Rise ?

Post by manwithnoname »

swaption wrote:
Bustoff wrote:At the risk of blurring the issue let me ask the following:
In order for the Fed to buy $85 billion of bonds per month from their primary dealers (Morgan Stanley, JP Morgan, et al) those primary dealers have to possess those bonds in order to sell them. We can infer that those primary dealers come into possession of those bonds by purchasing them.
When the primary dealers purchase all those bonds,those purchases in turn support the bond market. But according to the popular theory, QE drives rates down causing investors to flee bonds in favor of stocks. This begs the question, why would anyone sell bonds when prices are rising ? QE has extended the rally in bonds, not driven investors away from bonds. Thus, the effect seems to be that QE is directly helping the bond market more than the stock market.
Will try and keep this simple. The primary dealers never own the bonds, they just distribute. The proceeds go directly to the issuer. Putting aside consideration of money supply which gets a bit more complex, the end result is not all that diffferent than whay you might see when any big buyer is trying to corner the market in anything, essentially the price goes up. In this case, bond prices go up and it crowds out other investors. The first implication of rising prices is that interest rates go down and financing cost for just about everything else goes down and this boosts econcomic activity. But further, that $85 billion that that other investors are not using to buy treasuries and mbs needs to go somewhere, so demand increases for everything (i.e. if someone tries to corner the market for BMW's, that would be good for Mercedes). The most logical beneficiary is other fixed income (corporate bonds, etc.), but really any asset. But the further benefit of lower rates is that it drives people to take risk in order to get yield and this helps risky assets like high yield bonds and equities.

Not exactly. Primary dealers want to hold treasury securities because they get paid excess interest by fed reserve to hold them. When fed wants to stimulate economy it exchanges the T bonds for cash. Fed then holds bonds and collects $B in interest from US Treasury.

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Re: How Does QE Cause Equities to Rise ?

Post by Electron »

The Federal Reserve buys Treasury and Mortgage bonds on the open market which holds down longer term interest rates. They also control short term interest rates via the Fed Funds rate which will be held very low even beyond the end of QE.

The lower rates cause many investors to seek higher returns in risky assets. Lower borrowing costs and lower mortgage rates typically benefit the economy. Stock and bond markets look ahead six months or more and discount the future. Investors also tend to follow the herd once a trend is evident. That can result in assets becoming overvalued or undervalued.
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Re: How Does QE Cause Equities to Rise ?

Post by richard »

For those who believe in a mechanical link from QE purchases to bond yield and equities, I'd be interested to hear how continuing at $85 billion a month, rather than the estimated reduction to $75 billion, caused the magnitude of increases in bond and equity prices we saw on Wednesday.

Most analysts continue to forecast tapering will start within a small number of months, so we're talking about a change of a few tens of billions in purchases causing orders of magnitude larger changes in asset prices. The amount is also a blip in total outstanding treasuries.
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Re: How Does QE Cause Equities to Rise ?

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Interesting, as the OP asked the same question nearly one year ago (October 12, 2012): Why Does Quantitative Easing Help Stocks ?

A related thread: Why are bond prices falling? (this post)
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Re: How Does QE Cause Equities to Rise ?

Post by NightOwl »

Bustoff wrote:Does anyone know what the major banks do with the $85 billion per month they receive in QE stimulus ?
Or, same question phrased differently, how does the money injected into banks cause stock to rise.

We all understand that QE means the Fed purchases bonds from the major banks and pays for the bonds by crediting those major bank's reserve accounts with additional funds. This supposedly generates an expansion in the supply of central bank money.

But exactly how does that money, now in sitting the accounts of the major banks, make it into the equity market ?
My answer will doubtless be insufficiently theoretical, but here goes, from the perspective of a resident of NYC. The major banks have healthier balance sheets, so they pay out large bonuses to their employees. The NYC economy is heavily reliant on the health of the finance sector; the bankers go out and buy apartments, pay private school tuitions, hire nannies, personal trainers, private chefs, etc. Then people whom they hire, and I am one of them, take that money and send it to Vanguard where it gets invested in VTSAX.

I'm aware that $85 billion per month doesn't enter the equity markets this way, but this post is only partially tongue in cheek. Corporate profits are way, way up recently (the corporate world as a whole hasn't exactly suffered from QE), so corporations feel safe in paying higher salaries and giving larger bonuses, and money makes its way to their employees and then on to the equity market.

I'm sure someone will tell me, anecdotally, that salaries are stagnant where they live, and my anecdotal response is that Manhattan is booming, in large measure because the big bonuses are back (if indeed they ever left). Consensus around Bogleheads seems to be that QE hasn't been great for savers, but it's been great for corporate earnings and everything that flows from that.

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Re: How Does QE Cause Equities to Rise ?

Post by manwithnoname »

dmcmahon wrote:You might find this piece by John Hussman of interest re. QE and security prices:

http://www.hussmanfunds.com/wmc/wmc110307.htm

All securities have to be held by someone. This is why on this board people often groan when they hear that money is "flowing out of" [bonds/stocks/whatever]. Hussman's thesis: if the supply of bonds is reduced, and their yields suppressed, then they look less attractive to investors, who will, as a group, be willing to bid up other assets that have become relatively more attractive. Hussman isn't saying that the QE actually made the other assets attractive, mind you - he's saying that the equilibrium point versus now-unattractive bonds is shifted.
Try this version :

However, when short-term interest rates are at or close to zero, normal monetary policy can no longer lower interest rates.[13] Quantitative easing may then be used by monetary authorities to further stimulate the economy by purchasing assets of longer maturity than short-term government bonds, and thereby lowering longer-term interest rates further out on the yield curve.[14][15] Quantitative easing raises the prices of the financial assets bought, which lowers their yield.[16]

http://en.wikipedia.org/wiki/Quantitative_easing

In other words, when Fed purchases bonds with longer maturities it reduces the supply of bonds (or increases the supply of short term bonds with low interest rates) which results in investors increasing purchases of equities to get higher returns which raises the value of investors stock portfolios which makes investors feel wealthier so they will spend more money to increase the economy. Also Known as the wealth effect.
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Re: How Does QE Cause Equities to Rise ?

Post by Oicuryy »

Bustoff wrote:How Does QE Cause Equities to Rise ?
It doesn't.
Bustoff wrote:Does anyone know what the major banks do with the $85 billion per month they receive in QE stimulus ?
The same thing all banks do with any deposit. They set aside a small fraction as required reserves. Then they find someplace to loan out the rest.
Bustoff wrote:Or, same question phrased differently, how does the money injected into banks cause stock to rise.
That is a completely different question. Depositing money in banks does not cause stocks to rise. Speculators cause stock prices to rise by raising their bids and asks.
Bustoff wrote: We all understand that QE means the Fed purchases bonds from the major banks and pays for the bonds by crediting those major bank's reserve accounts with additional funds.
No, we all understand that QE means the Fed purchases Treasuries and agency MBS on the open market and pays the sellers with newly created money.
Bustoff wrote:This supposedly generates an expansion in the supply of central bank money.
There is no "supposedly" about it. The newly created money is an expansion of the supply of central bank money.
Bustoff wrote:But exactly how does that money, now in sitting the accounts of the major banks, make it into the equity market ?
There is no money in the equity market, only equities. Money the Fed creates in paper form stays in wallets and cash registers and bank vaults (and, rarely, mattresses). Money the Fed creates in book-entry form stays on the books of the Federal Reserve banks.

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Re: How Does QE Cause Equities to Rise ?

Post by Jack »

Oicuryy wrote:Money the Fed creates in book-entry form stays on the books of the Federal Reserve banks.
Not exactly. When the Fed buys a bond on the open market, the seller redeems it at a primary dealer, which is a designated commercial bank or brokerage which has an account at a primary dealer. The Fed pays for the bond by putting an electronic credit in the bank's account at the Federal Reserve and the bank puts a credit in the seller's account. The money in the Federal Reserve account belongs to the commercial bank, not the Federal Reserve bank. The Federal Reserve bank is just an account holder for the bank's money, just like a bank is an account holder for you. The newly created money is an asset of the commercial bank and a liability to the Federal Reserve. The Federal Reserve holds the newly purchased bond as a balancing asset.

The bank can then do what they like with their money. They have to keep some in their reserve account to meet reserve requirements. The rest they can take out of their reserve account to use to make loans and other investments.

Under normal circumstances, adding money to the banks reserve accounts leads to more lending and investment and stimulates the economy because they have more money to lend and invest. However we are currently in a liquidity trap where interest rates are near zero and yet are still not low enough to attract enough borrowers for investment. What this means is that the money in the reserve accounts, instead of being invested, just sits there doing nothing. This is a classic problem with the liquidity trap. The Fed has created over $3 trillion of new money and put it in the bankers' accounts and it has created very little stimulus. This misunderstanding of the liquidity trap is why many pundits, like Bill Gross, predicted high inflation and were completely wrong. In a liquidity trap, increases to the money supply do not lead the higher inflation.

So the first mechanism of quantitative easing, creating lots of money for investment, breaks down in a liquidity trap.

The second mechanism of quantitative easing is that by purchasing large amounts of longer term bonds, they push up the price of bonds, thus lower their interest rate. Again, this has had little effect, like pushing on a string because interest rates are already pretty low. It might have a small effect on the margin by lowering mortgage rates.

But as we saw last week, there is a much more important effect of quantitative easing in that it sends a signal to the market on future expectations about interest rates. In the previous Fed announcement, it wasn't directly the fact that they were talking about tapering, but that talk of tapering suggested the Fed might soon be intending to raise interest rates. The announcement last week to continue QE simply signals the Feds seriousness about maintaining low interest rates for a long time. The actual purchases of QE have less effect than indirect channel of expectations about future interest rates.
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Re: How Does QE Cause Equities to Rise ?

Post by Oicuryy »

Hi Jack,

Please see these two posts on the New York Fed's blog.

Will “Quantitative Easing” Trigger Inflation?

This one gives an explanation for why banks are not loaning out the excess reserves they have on deposit at Fed banks. In short, the Fed is paying them not to. From the banks point of view they have already made the best loan available. This explains why QE is not causing inflation and, by implication, why it has only had a modest effect on the economy.

Interest on Excess Reserves and Cash “Parked” at the Fed

This post shows that even if the Fed lowered the interest on reserves and the banks loaned the money elsewhere, the total amount of reserves held on deposit at Fed banks would not change. This is what I meant when I said that Fed-created money in book-entry form stays on the books of the Fed banks.

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Re: How Does QE Cause Equities to Rise ?

Post by Jack »

Oicuryy wrote:Will “Quantitative Easing” Trigger Inflation?

This one gives an explanation for why banks are not loaning out the excess reserves they have on deposit at Fed banks. In short, the Fed is paying them not to. From the banks point of view they have already made the best loan available. This explains why QE is not causing inflation and, by implication, why it has only had a modest effect on the economy.
This article is not about inflation now. It is about the strategy for preventing inflation when the Fed has to unwind quantitative easing. It can raise interest rates paid on reserves to keep them in reserve rather than stimulating loans and consumption. Currently they are only paying 0.25%, far to low to prevent banks from lending at 3% or much higher for commercial lending -- certainly not "the best loan available". They are only paying a tiny amount to put a floor on overnight lending between banks. This has nothing, currently to do with the low inflation rate. In fact, the Fed desperately wants the banks to take their excess reserves and do more lending, not hang onto them.
Oicuryy wrote:Interest on Excess Reserves and Cash “Parked” at the Fed

This post shows that even if the Fed lowered the interest on reserves and the banks loaned the money elsewhere, the total amount of reserves held on deposit at Fed banks would not change. This is what I meant when I said that Fed-created money in book-entry form stays on the books of the Fed banks.
Again, the Fed is only paying 0.25% on excess reserves. It has nothing to do with the total amount of money the banks hold on reserve. That is determined by the Fed's asset purchases.

What can change is the amount of excess reserves. Excess reserves can be converted by banks into loans typically at the fractional reserve rate of 10 to 1. For every billion dollars of excess reserves, the banks can create 10 billion dollars of new loans. When the Fed buys securities, it creates more excess reserves which support more lending and stimulate the economy. When the Fed sell securities, it withdraws excess reserves which shrinks the amount of lending and slows the economy.

At least that is the way it is supposed to work in normal times. In normal times excess reserves are only about $2 billion. Currently they are almost $2 trillion, nearly a thousand times as big. This is an indication of the liquidity trap. The banks are holding almost a thousand times their usual level of excess reserves and almost none of it is going into stimulative lending. There simply is very little demand from borrowers for money for expansion. The interest rate, even at the zero lower bound is too high to attract borrowers. Everyone is trying to deleverage, lowering their debt simultaneously. The excess reserves have nothing to do with 0.25% interest paid on their reserves. It has everything to do with low demand for lending.
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Re: How Does QE Cause Equities to Rise ?

Post by nedsaid »

The market is all about perceptions. That is it is perceived that the Federal Reserve is flooding the economy with money and the money is going into the stock market. The reality is somewhat different.

What is happening is an asset swap. The Fed is swapping cash for bonds. The total amount of private sector assets is exactly the same. The Fed has additional bonds on the balance sheet. The banks have more cash presumably to lend out. As the bonds mature or if at whatever point the Fed sells the bonds back into the market, the cash flows back to the Fed. Supposedly, the Fed pumps money into the economy when it buys bonds and takes money out when it sells bonds but the reality is that money supply is very difficult to control.

From my understanding, bank lending is up but most of the new money is not getting lent out. It is mostly sitting in bank reserves, probably in some cases being redeposited back at the Fed. Unless the funds are actually lent out by the banks, the bond buying in itself is not stimulating the economy or the stock market.

What Quantitative easing is doing is driving up the prices of bonds and lowering interest rates. They were in particular trying to bring down long term interest rates and thus mortgage rates. They are also buying mortgage instruments. As other posters have pointed out, the Federal Reserve Bank is attempting to encourage individuals to buy riskier investments like stocks. The Fed is also encouraging its member banks to lend money out rather than just buy treasuries. The Fed is also trying to stimulate the housing market.

So in my case, I am at age 54 with my retirement portfolio with 69% stocks and 31% fixed income. I would have more money in bonds if I could get decent interest on them. Until the recent surge in interest rates, many of the stocks I own yielded more than the bonds from the same company!! For some stocks, this might still be true! Hard to get excited about 10 year treasuries yielding 2.75%. So I am a small example of what is happening out there.

The other reason that these stimulus programs often don't work is human psychology. During the 2008-2009 bear market and the great recession, government programs to but more money in my pocket did not stimulate me. My thoughts were OMG, it must be worst than what they are saying and I better save more. Plus I want to save more to replenish my depleted retirement accounts. The Fed and Congress can stimulate all they want but if people don't spend and banks don't lend, it doesn't have the desired effect.

Another way of looking at this is that the Fed Balance Sheet is in many ways a Treasury bone yard. Just as the US Air Force has mothballed planes sitting in the desert sitting in reserve or for spare parts, the treasuries on the Fed Balance Sheet have effectively been retired. The profit the Fed makes on the Treasuries get paid back to the US Treasury. So the government is paying interest to itself! Of course, the Fed could sell some of it's treasuries and in effect "unretire" them. Just like the Air Force pulling jets out of the bone yard, refurbishing them, and putting them back into service.
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Re: How Does QE Cause Equities to Rise ?

Post by Electron »

It would be interesting to know how much of the QE money is actually in U.S. banks versus individual accounts or even Foreign countries. Mortgage and Treasury bonds are held and sold all over the world.

When each new QE was announced, I believe bond prices rose even before the Fed purchased any additional securities. Since there is a relationship between bond yields and equity prices, demand for equities increased on that basis along with the expectation of higher corporate earnings as the economy recovered.

One point that has not been discussed is that QE in the ideal case is a temporary program that is reversible.

The Federal Reserve expands its balance sheet until the economy has recovered and then sells their new bond holdings back on the open market. That would normalize their balance sheet and the newly created money disappears. Reversing QE may prove difficult and there is the option of holding bonds until maturity. Note also that the Federal Reserve may take a loss on the QE bond portfolio in the future if bonds are sold at higher yields and lower prices.
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Re: How Does QE Cause Equities to Rise ?

Post by Oicuryy »

Jack wrote:Currently they are only paying 0.25%, far to low to prevent banks from lending at 3% or much higher for commercial lending -- certainly not "the best loan available".
Jack wrote:The interest rate, even at the zero lower bound is too high to attract borrowers.
That seems contradictory. Are commercial borrows willing to pay 3% and higher? Or is 0.25% too high to attract borrowers?

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Re: How Does QE Cause Equities to Rise ?

Post by Jack »

No contradiction. The current federal funds rate is 0.25%. That is for very short term (overnight) loans between banks. The banks loan to their customers at rates several percent above the overnight rate to allow for default risk, duration risk and profit margin. They simply can't find enough qualified borrowers at those rates. Lowering the overnight rate by 0.25% would make no significant difference to lending. What they really need are rates a couple of percent below zero to make the market clear. They are stuck at the zero lower bound -- the liquidity trap.

The point is that the 0.25% rate on reserves is not what is keeping money stuck in the banks. That's only $5 billion a year for the excess reserves on every bank in the country. The problem is not enough demand from borrowers.
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Re: How Does QE Cause Equities to Rise ?

Post by Oicuryy »

Jack wrote:The point is that the 0.25% rate on reserves is not what is keeping money stuck in the banks. That's only $5 billion a year for the excess reserves on every bank in the country.
Please see this post on the New York Fed's blog.

Why Is There a “Zero Lower Bound” on Interest Rates?

Here is an excerpt.
The Federal Reserve, for example, currently pays an interest rate of 0.25 percent on the reserve balances that banks hold on deposit at the Fed. The ability to earn this interest gives banks an incentive to borrow funds in a range of markets (including the interbank market and the repo market) and thus has the effect of keeping market interest rates positive most of the time. The Federal Open Market Committee (FOMC) discussed the idea of reducing the interest on reserves (IOR) rate at its September [2011] meeting, but no action was taken. Reducing this rate would tend to lower short-term market interest rates and might push some rates below zero. The minutes from the meeting report that “many participants voiced concerns that reducing the IOR rate risked costly disruptions to money markets and to the intermediation of credit, and that the magnitude of such effects would be difficult to predict.”
That 0.25% interest rate is not only keeping banks from making loans. It is even encouraging them to borrow money elsewhere and loan it to the Fed.

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Re: How Does QE Cause Equities to Rise ?

Post by Jack »

No, the interest on reserves is not preventing loans. It is increasing a certain kind of loan.

What they are talking about is the federal funds rate. This is the rate at which banks borrow and loan with each other overnight. Because of the daily ebb and flow of funds in and out of banks -- checks deposited, checks paid, a new loan made -- banks sometimes need extra funds over night. These overnight loans are tiny fractions of a banks reserves, but are very important for keeping the mechanism of banking working. Otherwise banks might have to close on alternate days while transactions settle. This inter-bank lending occurs all the time, even when the Fed didn't pay interest. It is not preventing commercial lending now.

When we say that the Fed sets interest rates, this overnight rate is the rate that they set, through their mechanism of buying and selling securities and creating and destroying reserves. With the flood of reserves that the Fed has shoveled into banks this rate would normally be zero. But a rate of zero would cause the inter-bank lending mechanism to freeze up. There would be no reason for banks to lend to each other. So the Fed did something new, they started paying 0.25% interest on reserves in order to set a floor for overnight lending rates. This provides just enough lubrication to keep the inter-bank lending mechanism working.

This 0.25% rate only applies to inter-bank lending. It is not keeping reserves in banks. No bank is lending money to the Fed. Banks are simply lending to each other small amounts over night to keep their books straight, something they do exactly the same way in normal times. It is not preventing lending to commercial borrowers.

As I pointed out previously, the interest paid by the Fed for all the banks in the country is only $5 billion per year, not even enough to fuel the bankers private jets. The bankers need commercial loans to make their big profits. The Fed has lowered rates to near-zero in order to encourage lending. They are not trying to prevent lending. They are desperately trying to increase lending. Lending is too low because there is little demand for it. That is why inflation is low even though the Fed has printed over $2 trillion of new money. The money they created is just sitting in the banks. This has nothing to do with the tiny 0.25% interest the Fed is paying on reserves.
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Re: How Does QE Cause Equities to Rise ?

Post by richard »

Here are thoughts from two prominent economics professors:

"Pay special heed to quantitative magnitudes. For how long are we delaying the taper? One or two months? How much is the taper anyway, relative to the stock of relevant financial assets? Taking $10 to $15 billion off of $85 billion a month in purchases, when the asset stocks are in the trillions? Woo hoo."
http://marginalrevolution.com/marginalr ... bally.html

"Yes, the 10 or 15 billion a month is no big deal. But the future path of policy is a very big deal."
http://www.themoneyillusion.com/?p=23761

Nice to see that someone agrees with me that the real issue is the market's expectations regarding the future path of monetary policy.
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Re: How Does QE Cause Equities to Rise ?

Post by Bustoff »

Jack wrote:The Fed has lowered rates to near-zero in order to encourage lending. They are not trying to prevent lending. They are desperately trying to increase lending. Lending is too low because there is little demand for it. That is why inflation is low even though the Fed has printed over $2 trillion of new money. The money they created is just sitting in the banks.
+1
According to the experts, when the amount of spending and incomes grow faster than the production of goods, prices rise. When prices rise we call this inflation.
But printing money will only raise inflation if it doesn't offset falling credit. What matters is spending.

Inflation aside, those same experts suggest that in order to simply turn things around, the Central Bank must not only pump up income growth, but get the rate of income growth higher than the rate of interest on the accumulated debt. In other words, income needs to grow faster than debt grows.
Whether any of this is happening is my question ?
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