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The Mechanics of Quantitative Easing and M2

In recent months M2 has exploded higher by almost 3 trillion, generating enormous market chatter. This note briefly describes the mechanics of how Fed actions has led to a spike in bank deposits, which in turn has led to a large increase in M2. Note that M2 is largely comprised of different types of bank deposits, including demand deposits, savings deposits and time deposits. I’ll first go over the basic principles of central bank and commercial bank money creation, then apply the principles to recent events.

Principles of Money Creation

Bank deposits are either created by commercial banks through credit creation, or indirectly by the Fed when it creates central bank reserves.  When a commercial bank makes a loan or purchases an asset, it creates money (bank deposits) out of thin air to pay for it. Commercial banks do not lend out money deposited with them; they create money. For example, someone who goes to the local commercial bank and is approved for a $1 million loan will simply log in to his bank account and see an additional $1 million on deposit. The commercial bank electronically created those deposits through a few keystrokes. The newly created $1 million deposit liability on the bank’s balance sheet is balanced by a newly created $1 million loan asset.

The Fed does a similar type of credit creation when it purchases assets through QE, but instead it creates central bank reserves. Reserves are a special type of money that only commercial banks and select other entities can hold, such as the U.S. Government. Commercial banks essentially have a checking account at the Fed that holds reserves, just as individuals have a checking account at a commercial bank that holds bank deposits. When the Fed buys $1 million in Treasury securities from an investor during its QE purchases, the Fed credits the investor’s bank’s Fed account with $1 million in reserves. The investor’s bank in turn credits the investor’s bank account with $1 million in bank deposits. At the end of the day, the Fed’s balance sheet will have $1 million in Treasury securities as an asset, balanced by $1 million in central bank reserves as a liability. The investor’s bank will have $1 million in reserves in assets, balanced by $1 million deposit liability to the investor. The investor will have swapped his $1 million in Treasuries for $1 million in bank deposits.

Fed Balance Sheet Expansion During COVID-19 Panic

Since the COVID-19 panic in March, the Fed has massively expanded its balance sheet through asset purchases and an alphabet soup of Section 13(3) lending facilities. Just to make things simpler, I will focus on the Fed’s balance sheet expansion through QE purchases FX swap loans, since those two are by far the largest contributors. In the two figures above, you will see that the Fed’s balance sheet exploded by around $2.5 trillion year to date, mostly from purchases of Treasury securities and Agency MBS. That increase has been mirrored in increased reserve holdings of commercial banks and the U.S. Treasury, which together also rose by around $2.5 trillion.

Reserves move from commercial banks to the Treasury’s General Account (“TGA”) through Treasury issuance. For example, when an investor purchases $1 million in Treasury bills he will wire $1 million in bank deposits to the Treasury in exchange for the securities. However, the Treasury only accepts payment in reserves. Behind the scenes, investor’s commercial bank will settle the payment on the investor’s behalf by sending $1 million in reserves to the TGA as payment. At the end of the day the commercial bank will have $1 million fewer in reserves, balanced $1 million less in deposit liabilities to the investor. The TGA will have $1 million more in reserves.

In March investors moved their money from banks deposits to Treasury bills, which are safer cash like investments. Reserves flowed from commercial banks to the TGA as investors purchased around $2.5 trillion in newly issued bills. Some of those purchases were direct, others indirectly through money market funds. Money market funds received around $1 trillion in inflows in March, which was largely invested into Treasury bills. The two charts below show the surge in bill issuance and money fund assets.

Commercial Bank Balance Sheets during COVID-19

Since March the level of reserves held by commercial banks exploded due to Fed actions, but the amount of bank credit also significantly increased. Many corporations were worried about the impact of COVID-19 and increased their cash holdings by borrowing from banks. Higher reserve levels and bank credit led to an explosion in bank deposits, which in turn led to an explosion in M2. Note that in the chart above I also include Fed FX swaps in the section of bank liabilities. Fed FX swaps create reserves, but they are balanced by an FX swap liability rather than bank deposits. (Technical note: the FX swap shows up on the balance sheet of a foreign bank’s head office, and appears on the U.S. branch office’s balance sheet as a ‘due to foreign office.’)

Understanding the drivers of the increase in bank deposits can be helpful in assessing their impact on economic activity. Growth in bank deposits due to credit growth from economic optimism is very different from bank deposit growth due to QE and corporate fear. The former likely leads to more purchases for goods and services, the latter not so much. Corporations did not borrow to invest in the future, they borrowed to hoard cash amidst uncertainty. QE essentially converts Treasury securities into bank deposits, which is basically one form of money to another. Money that was saved in Treasuries was not money that was going to be spent on goods and services. It seems more likely to be moved into other financial assets, like corporate debt or equities. Indeed, corporate debt spreads have narrowed significantly and equity prices have skyrocketed. 


  1. Josh F

    Do the mechanics differ if the treasury being sold to the Fed is owned by the bank itself and not an investor with a bank account? Is a bank deposit still created?

    • Fed Guy

      If a bank sells a Treasury to the Fed, then the bank essentially exchanges $100 in Treasury securities for $100 in newly created Fed reserves. No bank deposits are created at the end of the transaction.

  2. James

    Love this website, please come out with more stuff! Love it! Ive signed up to the newsletter, I need more of this.

    So are the ‘Sacred Mystic’ Bank Reserves ‘base money?’
    Do they live in ‘Financial Institution Heaven?’ meaning, do they stay in the pipe line of the financial economy and do not cross into the ‘real world’ of the real economy?

  3. TB

    Very informative post but I’m still not entire clear on the main driver. Is M2 growth mostly caused by:
    1) Increased bank lending/credit to corporations worried about their cashflow?
    2) FED purchases of treasuries from the non-bank sector?


    • Fed Guy

      They both raise M2 – so $100 increase in bank lending increases M2 by $100, and $100 in QE purchases from non-banks also increase M2 by $100. The relative strength of these two factors changes over time. Right now QE purchases are $120b a month, while bank credit creation has been around $50b a month (see Federal Reserve H8). So QE has a stronger impact. In “normal” times there is no QE so M2 increases would largely reflect banks creating loans/buying assets.

      • bm

        But does QE buy from non-banks? I thought that only primary dealers participating in QE program sell US Treasuries to FED.

        • Fed Guy

          Yes you are right. In that instance the PDs are are middle-men. Investor sells to PDs, then PDs sell to Fed. They are an intermediary between the Fed and the non-PD investors.

  4. Jared Bockoff

    The missing piece is *how do reserves in the TGA account become legal tender by the Treasury*?

    Do they have special ability to convert?

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