Why QE doesn’t directly cause money supply growth
Central banks aren’t as powerful as many people imagine
We commonly refer to quantitative easing (QE) as money printing, but in this article I’m going to provide a concrete example of how QE doesn’t necessarily lead directly to an increased money supply.
In our current financial system commercial banks create money when they originate a loan*. Under this system the commercial banking sector is responsible for creating new money, not the Federal Reserve as many people imagine.
*I wrote an entire article on this topic if you want to learn more about how banks create money.
As a brief aside, the architecture of our financial system is a great thing for anyone who is concerned about a Central Bank Digital Currency (CBDC). If the Federal Reserve launched a CBDC it would deprive large banks like JP Morgan and Goldman Sachs of the ability to create new money.
The banks are aware of this and they’re going to push back hard against a government-backed digital currency. The big banks don’t want to lose the ability to lend money since this is a big source of power for them.
So if QE is not money printing, what is it? Well the Fed is creating bank reserves, which are a special type of asset that can only circulate in the banking system.
For example, JP Morgan can pay Goldman Sachs with bank reserves, but you cannot take bank reserves to the grocery store to buy some hotdogs and a six pack. It just doesn’t work like that.
Bank reserves are base money and by injecting them into the banking system the Fed hopes that it will cause banks to lend more and increase the money supply, but the Fed cannot guarantee that this will happen. For a great example let’s turn to Japan.
In this first chart we can see that the BOJ’s balance sheet has gone parabolic in the last decade. In other words the Bank of Japan has done a whole boatload of QE, buying trillions of Yen worth of JGBs (the Japanese equivalent of Treasuries) in the process.
That’s all very impressive, and you might think that it would lead to lots of inflation. However, it hasn’t. Let’s look at this second chart which represents Japan’s M2 money supply. In this chart you can clearly see that despite the BOJ’s balance sheet going parabolic, the money supply in Japan has only grown at a modest rate.
When central banks do QE they’re hoping that it will cause commercial banks to make more loans which will stimulate economic activity. However, the central banks cannot force the commercial banks to make loans.
This is why there’s not a direct relationship between QE and money supply growth. It’s also why you’ll occasionally hear people refer to QE as like “pushing on a wet noodle.” The central banks want to push more money into the system, but the outcome is often that the noodle just squirms around rather than moving forward.
Is QE money printing? Yes, in some respect. Central banks are creating new assets (bank reserves) to inject into the financial system. However, these assets are not spendable money and cannot become money unless the commercial banks decide to make more loans.
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