QE: How does the Fed do it?
November 18, 2010
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A student sent me a clever YouTube video cartoon trying to explain QE2. It scores some points on Bernanke, the Fed, and Goldman Sachs but either intentionally or unintentionally confuses demand-pull and cost-push inflation to push its point of view. It is nevertheless very entertaining.
QE Explained / A Response
I was left left with the question that is the title of this post and found this, which seemed to sum it up nicely: (From: Quora.com)
Why does the Fed buy treasury bonds through Goldman Sachs instead of from the treasury? How did this happen?
Vince de Baca, AB Econ from Princeton, Wharton MBA
AB Econ from Princeton, Wharton MBA Economics
- The Fed buys securities from banks to inject liquidity into those institutions to ensure a low cost credit supply and bank liquidity.
- If the Fed bought from the Treasury, the funds could only be used to close fiscal deficits, not having the same benefits to the financial sector and economy at large (eg lower interest rates, bank solvency).
- Also if the Treasury exclusively sold bonds to the Fed, it would diminish market confidence in the dollar and likely create inflationary expectations.
- The Fed announces the times at which it will buy securities and the price at which it will buy them. The Fed price in Quantitative Easing is always greater than the market price for the same securities. Given this information in advance, market participants either (a) unload Treasury bonds from their books at a great profit (since Treasuries are trading at all time highs) or (b) go out into the open market and purchase Treasury bonds that cost less than the Fed’s announced prices, creating an arbitrage effect.
- Q: If the market price of an apple is $1.00, and I offer to buy a half a trillion apples for $1.02, how many would you sell me?
- A: As many as you bloody can. I’d be in effect giving you an easy profit of billions. Especially because the market price will drop after my buying program ceases.
- Anyone who can afford to buy up billions in Treasuries in advance of the Fed’s purchases can play (or has a few billion they’d like to short when the Treasury market is at an all time high). Speaking of which, does anyone have a couple billion bucks I can borrow?
They don’t just buy from Goldman — they buy from all the primary dealers in an auction. The primary dealers are the same institutions that are eligible to buy from the Treasury during monthly bond auctions: banks like Goldman, Morgan Stanley, JPMorgan, Citi, etc. Here’s how the process works:
- A few days in advance of the auction, the Fed provides a list of the specific bonds and amounts they’d like to buy
- At a specific time, all the primary dealers submit their best offers to the Fed, i.e. they submit the lowest price at which they’d be willing to sell.
- The Fed buys from those dealers who offer the lowest price.
They buy via auction rather than buying from the Treasury since it increases transparency and helps them get a better price.