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.
45 comments On The Mechanics of Quantitative Easing and M2
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?
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.
But in the first place the bank had do buy the treasury, right? So in this process money has been created right? Not investment advice. Just my opinion.
Yes that’s is right. Bank creates bank deposits to pay for the treasury when it first bought it
So I think I understand the M2 creation now. It’s not from the increase in reserves as that’s not part of M2, it’s from when the commercial banks acting as primary dealers buy treasuries and MBS from non-bank investors. The commercial banks are able to create deposits for those investors and the Fed balances that liability by creating them a reserve asset. For M2 to increase then, the Fed has to buy more treasuries from non-bank investors than those non-bank investors buy from Primary Dealers(commercial banks). So given the purpose of QE is to reduce the supply of long-term treasury bonds and MBS and hence push up their price, the size of any QE program will be dictated by the current government deficit and new mortgages/MBS issuance. The Fed must buy more existing bonds than bonds being created from the deficit and new MBS issued from new mortgages.
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?
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?
Thanks!
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.
But does QE buy from non-banks? I thought that only primary dealers participating in QE program sell US Treasuries to FED.
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.
Can you explain this in more detail? Why would a PD want to use its cash to buy treasuries from investors when the US Treasury will only give it Reserves. Reserves can’t be lent out in the private economy so they can get a nice interest rate on them. Seems like banks would prefer cash?
I think I figured out my question. It’s because the commercial banks just create the deposit to buy the treasuries from the non-bank investor. That’s where the monetary inflation occurs.
So, to clarify, a purchase of bonds from the US Treasury at auction by a PD doesn’t affect M2 – it simply results in transfers between reserve accounts and the TGA?
Only QE activity, that originates with non-bank counterparties has any effect on money supply?
Thanks in advance. Nearly got this!
The missing piece is *how do reserves in the TGA account become legal tender by the Treasury*?
Do they have special ability to convert?
Reserves are already ‘legal tender’ – after all how else does the Government spend its TGA account? I have a post specifically addressing this topic as well.
I LOVE your blog first off. But this was the only comment on this post that doesn’t make sense to me. The whole Lacy Hunt argument about structural disinflation is based around this idea that reserves are NOT legal tender. And that you would need a change to the Federal Reserve Act to make it such. I get that the Treasury will spend what’s in that TGA account, but I would love to understand this legal tender vs reserves nuance better.
Thanks! Reserves are a special type of money created by the Fed and can only be held by those with an account at the Fed (mostly banks). If a bank buys something from another bank, it will be settled in reserves as both have Fed accounts. It is a type of risk free money, since it is created by the Fed and the Fed cannot default. Bank deposits (the numbers in your bank account), are created by commercial banks and not risk free since the bank can become insolvent. The two types of money are connected with via our two tiered monetary system.
Hi FedGuy, thanks for writing so much to share your views, they have been really helpful. May I ask about your broader macroeconomic views on the economy, currently and going forward into the next decade? How do you think policy will evolve too?
Hi,
Thanks for your post! Your blog is super informative.
I had one question – Can you explain what happens when bonds mature on the Fed’s balance sheet? Is it right to assume that when bond’s mature on the Fed’ balance sheet that the Treasury will have to repay the principal back to the Federal Reserve and bank reserves also fall? Is that how this works?
If the Fed is allowing the bonds to roll off (“quantitative tightening”) then the Treasury repays the Fed and total reserves fall. If the Fed is reinvesting like they are now, then the Fed will just take the repaid principal and roll it over into newly issued Treasury debt so the level of reserves stays the same.
Thanks! And just to be super clear here (sorry to be a pest, I find the topic you’re talking about here re: bank reserves super interesting) total reserve only decline if the bond rolls over PLUS Treasury decides to issue bonds either to the bank sector or public sector, is that correct? Because the act itself of allowing the bond to roll off (‘QT’/Treasury repays the Fed) doesn’t cause bank reserves in of itself to decline.
This atleast appears to be what the NY Fed is saying: https://libertystreeteconomics.newyorkfed.org/2017/07/how-the-fed-changes-the-size-of-its-balance-sheet.html
Is that how you interpret that as well? Thank you again for taking the time to clarify.
MN
Reserves decline if the Fed decides to NOT reinvest Treasury holdings. That means the Fed receives repayment from U.S. Treasury and does not reinvest it (it just goes poof – $100 in Treasury assets disappears along with $100 in reserve liabilities. That is how reserves decline). Page 28 of the 2018 SOMA Report may be helpful. Treasury issuing to the public/bank does not change reserve levels, only Fed action changes that.
Edit: The U.S. Treasury can repay the Treasuries held by the Fed through either issuing new debt the public/bank sector or through raising taxes. Either way draws reserves out of the banking sector into the Treasury’s account, and is then sent to the Fed. On the Fed’s balance sheet its Treasury Asset is repaid and its reserve liabilities (which it created out of thin air to begin with) disappears.
That’s great. Thanks for clarifying.
MN
This is fantastic, thanks. Question on FX swaps. Can you elaborate on how Fed FX swaps create reserves? My understanding is Fed swaps USD/FX with foreign CB –> foreign CB lends USD to a respective domestic bank –> respective domestic bank ultimately depos USD at Fed (ie reserves) and the liability “due to head office” balances the asset. Is that right? Thanks!
Yes that’s right. An entity must have a Fed account to hold reserves. For example, BNP has a Fed account via it’s New York branch office. If BNP borrows USD from the ECB (who borrows from the Fed via FX Swap), the reserves ultimately end up in BNP’s account at the Fed. From the branch office perspective, it is a reserve asset and the liability is a due to Head Office. Note that on the regulatory filings due to/due from is netted out so you only see the net flow.
Hi Fed Guy,
May I ask why the swap has to be repaid? I thought that a FX swap say between ECB and the Fed will entail a FX transfer of euros and dollars at a certain FX rate, and this will be permanent?
Central bank FX swaps are loans that are repaid at maturity. A central bank will run auctions for loans of various tenors e.g. 1 month loan, 1 week loan etc.
Fantastic and informative article. I am struggling to understand if QE is inflationary. Steve Van Metre claims that when the Fed purchases a security, the bank reserve they receive is just collateral, and CANNOT be used for anything except as a backing for new loans, which they don’t want to make since they have to use their own capital. He says since it’s only collateral, they CANNOT buy more treasuries. https://www.youtube.com/watch?v=zbSvNO4wD9U. I cannot find any clarification on this. If they could, then unless I’m missing something, that would be monetizing the debt, which would be highly inflationary. I emailed the Fed to ask if the banks can buy new treasuries with their new reserves, but haven’t heard back. If what he’s saying is true, I’d say QE isn’t inflationary, but I cannot see any motivation for the banks to do this. Can you please comment on this?
QE changes the composition of money in the financial system. It swaps Treasuries, which are a form of money, for reserves, another form of money. Reserves are a type of money created by the Fed that can only be held by entities with an account at the Fed (generally speaking, banks). Banks use reserves when they make payments to other entities that have reserve accounts, like other banks or the U.S. Treasury. For example, during April tax season you can see reserves in the banking system decline by a few hundred billion as tax payments are made, and the Treasury’s account rise by a few hundred billion. When the Federal government spends, you will also see declines in the Treasury’s Fed account. So reserves can and do get spent freely.
Banks have been purchasing hundreds of billions in Treasuries recently, in part because their yield higher than reserves (which currently only yield 0.15%). See this post for more details.
Corporate accountant here- I’ve read several of your posts and they all seem correct from my perspective which is mainly informed by Modern Monetary Theory (MMT) plus my accounting background. Do you have an opinion on MMT? It seems like the only school of thought that gets this stuff right, especially the endogenous money aspect (loans create deposits).
I think MMT is an accurate description of our monetary system, but may not be true for other systems. I imagine if an emerging market were to run large deficits there would immediately be capital flight, the currency would decline, and inflation would rapidly rise. The more public confidence there is an a monetary system, the more MMT like it becomes.
This is might be the most underrated site on the internet. Can somebody please arrange a discussion between you and George Gammon/ Jeff snider?
“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.”
But is there actually anything stopping the owners of the new deposits from spending that money on whatever they want? Suppose they decide to start buying commodities like crazy. The bottom line is it’s all new money right? So if there’s billions in new deposit money, the only thing standing in the way of massive inflation is the sentiment of pension funds etc. ? What scares me is that when sentiment changes, it’ll change for everyone at the same time.
I keep reading from experts that QE “doesn’t” cause inflation, but when I read the detailed explanations of how it works, it sounds more like we should be saying that QE “hasn’t” caused inflation. Yet.
What am I missing?
Of course they wont spend it freely on anything they want, ultimately the loan has to be paid back. If firms cannot find any good investment opportunities, which is very much the case now, then they wont spend that money they just borrowed. As explained by Joseph firms are hoarding cash in case of emergencies.
Generally, if deposits are created via bank lending then presumably the borrowers will be purchasing physical assets in the real economy, and driving growth in prices of what they are buying. This can be inflationary for the real economy and will show up in metrics like CPI.
If deposits are created from short-term loans being drawn down in fear, then that will likely just be cash sitting on a corporate balance sheet and not spent into the economy, resulting in no inflation observed. Likewise, if QE is just substituting a Treasury for a reserve, both financial assets, that does not change the marginal desire to spend, and thus, non-inflationary for CPI (but likely inflationary for asset prices).
That is what he is contrasting.
To be clear Joseph, when primary dealers purchase Treasuries directly at auction, they must fund those purchases from their existing stock of reserves held at the Fed? And, if banks/PDs purchase Treasuries from a private client (e.g. an asset manager), those purchases are funded by deposit creation?
Thanks!
PDs are not the same as banks. Banks have reserve accounts and their purchases from non-banks are funded by deposit creation. PDs have accounts at banks like you and I, and their purchases done with bank deposits. When a PD buys a Treasury at auction it is paying with bank deposits, but its bank is settling the payment on the PD’s behalf with Treasury using existing bank reserves.
Thanks. Most PDs are also banks though, right? For the PDs that are banks, do they fund UST purchases then by debiting their respective reserve accounts at the Fed?
Almost all of them are affiliated with a bank – ie securities dealers owned by a bank, but not itself a bank. A few of them are banks with dealer businesses. These are usually the foreign PDs. Here’s a list of PDs for reference. If they are bank then yes payments are made from reserve balances held in their Fed account.
“If they are bank then yes payments are made from reserve balances held in their Fed account.“
But then you say:
Joseph Wang
July 28, 2021 at 1:25 pm
“Yes that’s is right. Bank creates bank deposits to pay for the treasury when it first bought it“
“Banks have reserve accounts and their purchases from non-banks are funded by deposit creation. “
So if a bank buys treasuries from the fed
, it does so with reserves
But if it buys treasuries from the PDs or private investors, then it does so with deposits (that the bank can create from thin air) ?
And then the bank sells the treasury that it bought with created deposits to the fed in exchange for reserves ?
It seems to me rather critical to know exactly what % of QE is the fed buying from banks, and what % is the fed buying from PDs
Is this information available anywhere ?
“Right now QE purchases are $120b a month, while bank credit creation has been around $50b a month (see Federal Reserve H8)”
But QE only affects M2 if the purchases are from non-banks , right ?
I would assume that all Fed purchases are from non-banks. Banks are buying a lot of Treasuries right now. They are not selling to the Fed.
One more fundamental question…are reserves held in TGA part of the monetary base?
Thanks again.
No they are outside of the money supply
Can you comment on the Acharya et al Jackson Hole paper on end of QE not being benign making the news rounds (generally referred to as Rajan and co authors paper)
M1 has risen much faster than M2 post pandemic. I cant clearly draw parallels between this and increase in inflation. Does it mean anything or there isn’t much of a difference anymore?