- Hey, everyone. It feels good to be back with a new video after taking a bit of
a break from YouTube. Before getting to the video, I just wanted to take a couple of seconds to say thank you to all of you
for supporting the channel. This came in from YouTube last week, which was pretty cool for me, and obviously the growth of the channel would not be possible
without all of your support. So again, thank you, and I hope that you enjoy this video. Stock markets swiftly recovered from the deep losses that they experienced when the COVID-19 pandemic began. Good news, right? Unless all of this is an illusion caused by the Federal Reserve
printing huge piles of money. If asset prices reflect
expectations about the future, the market rising should
be viewed with optimism. But there might be less optimism, and there may even be pessimism about a market that is being
artificially propped up up by a central bank. What if the central bank
can't print any more money and stock prices drop? And how can all of this
money printing be good for the country's currency? I'm Ben Felix, Portfolio
Manager at PWL Capital. In this episode of
"Common Sense Investing," I'm going to tell you
what's really happening when you hear that the
Fed is printing money. (upbeat music) Central bank actions are an
inherently political topic. The information in this video
does not aim to take a side on the level of involvement that central banks should
have in the economy. Rather, it aims to explain the mechanics of some of the policy tools
that central banks use and their potential impact on currencies and financial markets. You've probably heard that
the US Federal Reserve, the central bank of the
world's largest economy, is printing money. Lots and lots of money. You may have also heard
that the money printing is the reason that the stock
market has recovered so quickly from the recent downturn, despite continued economic concerns. To understand what money printing means and how it might be related
to the stock market, we first need to understand what money is. Money is important to any
functioning capitalist economy. It facilitates the exchange
of goods and services, serves as the unit of account, providing a standardized way
to measure income, wealth, asset prices and profits and act as a store of value, allowing individuals and businesses to store wealth in a convenient form. When we are talking about money today, we are talking about fiat money. Fiat means "let it be" in Latin and refers to money that
has no intrinsic value but is used in an economy based
on government pronouncement. Ultimately, the stability of the fiat money used in an economy comes from that economy's
productive capacity and the state's endorsement
and protection of its use. In other words, money
is a social construct that facilitates economic activity. The government does not
create most of the money in the economy. Governments are the only entity that can print physical currency, as in creating paper bills and coins. But that's a small proportion
of the money in the economy. Most of the money in the
economy comes from private banks making loans to
individuals and businesses. Every time that a new loan is issued, it creates a loan, which
is an asset to the bank and a liability to the customer, and a deposit, which is
a liability to the bank and an asset to the customer. Money is electronically created out of thin air, every
day by private banks. Private banks are
competing with each other to create money by issuing loans. The primary constraint
that private banks face is their ability to remain profitable. They can't make too
many loans to borrowers that will not be able to
eventually pay the loans back. This constraint on
lending is very different from the stereotypical
characterization of banking. The ideas of fractional reserve banking and the money multiplier effect, where banks take in deposits and then make loans based on
those deposits, are incorrect. That's right, fractional reserve banking is not how money works
in the modern economy. In both Canada and the US, private banks don't even
have reserve requirements. As long as the bank believes that they will make a profit on a loan, they will make the loan, creating new money out of thin air. The practical implication of this reality is that contrary to common belief, borrowing is the money creating process that allows for saving and
not the other way around. As money moves around
within the banking system, private banks need to keep an eye on their net flows of money. If a bank extends a loan to a customer running a manufacturing business, and the customer goes and buys equipment from their supplier, who
uses a different bank, the money leaves the customer's bank and moves to the supplier's bank. The money has not left the
private banking system, but the customer's bank
has had a net negative flow from the transaction. Banks clear their net flows through a central clearing house at the end of each day, using a special kind of
money called bank reserves. If during a given day, more money leaves the bank than comes in, the bank owes the central clearing house. The bank will cover that shortfall by borrowing reserves in the
overnight lending market. A bank with a net
positive flow for that day might lend their excess money to a bank with a net negative flow. Deposits, while not required for lending, are still important for banks because it is cheaper to
pay interest on deposits than it is to borrow in the
overnight lending market. But deposits are not required for lending, due to the existence of the
overnight lending market. A bank will always make a loan that they expect to be profitable, knowing that they can borrow
to settle their net flows in the overnight lending market. The interest rate on
overnight loans between banks is important to the economy. If the overnight lending rate increases, then banks need to charge
their customers more for loans in order to remain profitable. Central banks try to influence the rate at which banks lend to each other by supplying or removing liquidity from the overnight lending market. In some extreme cases, like
the financial crisis in 2008, banks have trouble
settling their net flows in the overnight lending market. This is where the central bank
becomes an important backstop to the banking system. Instead of allowing the overnight
lending rate to skyrocket, due to a lack of liquidity, central banks will create
a special kind of money, called bank reserves, out of thin air to provide
liquidity to private banks. This is why central
banks are referred to as, "The lender of last resort." As the bank of banks, central banks are responsible
for executing monetary policy. Monetary policy consists
of central bank actions that are designed to
promote maximum employment, stable prices and moderate
long-term interest rates. Setting a target for the
overnight lending rate is one of the ways that central banks execute monetary policy. By affecting the overnight lending rate, central banks can, to an extent, influence the demand for loans
from credit worthy borrowers in the private banking system. If interest rates are lower, more people should be willing
and able to take out loans, and the economy should be stimulated. Raising the overnight rate
should have the opposite effect. One of the ways that central banks influence the overnight lending rate is through open market operations. Open market operations involve the central bank transacting
with private banks to add or remove the
supply of bank reserves from the private banking system. In order to decrease the
overnight lending rate, the central bank would
create bank reserves to purchase short-term
government securities from the private bank. An important note here is that when the central
bank purchases securities from the private bank, the net effect on the private banking system's
balance sheet is neutral. After the transaction, the
central bank has a liability, the bank reserves that they
created out of thin air and an asset, the short-term
government security that they purchased from the private bank. The private bank has sold some short-term
government securities and gained bank reserves. The net amount of their
financial assets has not changed. In open market operations, the central bank is not
literally printing currency. They are creating bank reserves and swapping them for
short-term government debt in an effort to influence
short-term interest rates. When the central bank is purchasing large amounts of assets from the private sector in an effort to lower the
overnight lending rate, the private banks may end up with large positive settlement balances at the end of the day. When this happens, the central bank will pay interest on the positive balances. In that sense, bank reserves are really just another form of short-term government debt. Affecting the overnight lending rate is known as a conventional
approach to monetary policy. This conventional approach starts to run into some problems when the overnight lending rate is already at or near zero, like it is today. This started happening in the US during the 2008 financial crisis. And it happened in Japan as early as 2001. In both cases, the solution was an unconventional
monetary policy tool, known as quantitative easing or QE. The execution of QE is nearly identical to the open market
operations that are used to influence short-term
interest rates every day, with a few key differences. QE involves buying much larger amounts of longer maturity government bonds and other private sector assets, like corporate bonds and
asset-backed securities. Remember, the activity
of creating bank reserves out of thin air to purchase short-term
government securities from private banks is a routine activity in executing monetary policy, and private banks routinely
create money every single day. But, despite its similarities, it is quantitative easing that gets associated with
the term "money printing." Like other open market operations, QE is an asset swap, where the central bank
creates bank reserves, the special money that banks use in the overnight lending market, and uses them to purchase
assets from private banks. This asset swap does not affect the private
sector's balance sheet, but it does alter the composition of the private sector's assets, which is exactly what the
central bank is hoping for. The intention of QE is to reduce
longer-term interest rates to stimulate economic activity. And there are several theories about how it might be
able to accomplish that. Portfolio balance theory suggests that removing huge amounts of long-term government bonds, corporate bonds and
asset backed securities from the open market and sticking them on the
central bank's balance sheet will increase the market price of those types of securities
in the private sector, reducing their yields. This shift in the yield curve could make a more favorable environment for businesses and
individuals to borrow money, kick-starting the economic engine. Signaling theory suggests that
the central banks commitment to buying huge amounts of assets could signal their commitment to continued accommodative
monetary policy in the future, making people more comfortable with borrowing and investing today. Both of these theories
also inherently suggest that QE should have a positive
impact on stock prices, a more favorable environment for borrowing and an expectation of continued accommodative monetary policy should mean less perceived risk and a more favorable
outlook in the market. Less risk and a better outlook should mean higher asset
prices across the board, including for stocks. Empirically, there is evidence that QE does impact stock prices positively. In a 2014 paper, titled, "Evaluating Asset- Market Effects of Unconventional Monetary Policy: A Cross-Country Comparison," the authors use an event
study analysis to show that within their sample, a 25
basis point surprise reduction in the 10-year US treasury yield results in a 0.7%
increase in stock prices. The authors also indicate that unconventional monetary policy tools become less impactful to equity prices when short-term rates are
already at or close to zero, like they are right now. None of this should be
particularly surprising. When a central bank executes an accommodative monetary policy action designed to stimulate the economy, market participants expect
there to be a positive effect. This expectation through various channels is reflected in rising stock prices. I think it's a bit of a stretch to say that central
banks are single-handedly propping up the stock market. Monetary policy and expectations about future monetary policy are important inputs in
the asset pricing equation, but there are many other inputs. The bigger concern that many people have when they hear about money printing is the effect on inflation. Inflation was a major concern when the Federal Reserve
originally rolled out QE in 2008, even prompting a group
of economists, professors and fund managers to write an open letter to then Chairman of the
Federal Reserve, Ben Bernanke, voicing their inflationary concerns. Let's remember what's going on here. Banks are selling
long-term government bonds, corporate bonds, and other
assets to the central bank in exchange for bank reserves, which are really just another form of short-term government debt. This is where the disconnect between the image of money printing and the reality of quantitative easing becomes most evident. Quantitative easing
results in the creation, out of thin air, of bank reserves, leaving the net financial assets of the private sector unaffected. The relationship between
increasing bank reserves and private banks creating
money by lending to customers, which could be inflationary,
does not exist. This was examined in the US in a 2010 finance and economics discussion series working paper titled, "Money, Reserves and the
Transmission of Monetary Policy: Does the Money Multiplier Exist?" The authors concluded that, "Changes in reserves are unrelated to changes in lending. And open market operations do not have a direct impact on lending. We conclude that the
textbook treatment of money in the transmission
mechanism can be rejected. Specifically, our results indicate that bank loan supply does
not respond to changes in monetary policy through
a bank lending channel, no matter how we group the banks." The Bank of England,
similarly dispelled the idea that lending is related to bank reserves. in 2014 bulletin titled, "Money Creation in the Modern Economy." They explain, "Reserves are an IOU from the Central Bank to commercial banks. Those banks can use them to
make payments to each other, but they cannot lend them out to consumers in the economy who do not hold reserves accounts. When banks make additional loans, they are matched by extra deposits. The amount of reserves does not change." At a time when central banks are using unconventional
monetary policy tools to stimulate economic activity, beyond what was possible through conventional monetary policy, deflation is likely to
be a bigger concern. This has been the experience in Japan, where we have the longest
running QE experiment. Money is the medium that
facilitates economic activity. Most of the money in the
economy comes from private banks making loans to
individuals and businesses. The demand for loans from
credit worthy borrowers is what dictates the amount
of money in the economy. Central banks attempt
to influence this demand by raising or lowering
overnight lending rates. But when that rate is already at zero, they might use unconventional
monetary policy to affect longer-term interest rates. Unconventional monetary policy
should increase asset prices, including stock prices, but it's not sufficient to single-handedly prop up the stock market. Finally, the idea that all of this so-called money printing will lead to it inflation, is misguided. Quantitative easing is an asset swap that changes the composition of private sector financial assets without affecting the net amount of private sector assets. Further, private banks do
not lend out bank reserves to their customers. Money creation in the economy comes from demand for loans
from credit worthy borrowers. At a time when a central bank has decided that unconventional monetary
policy is necessary, that demand for loans must be low, meaning that deflation is a
bigger concern for the economy. Now that we've gone through the details of how central banks
execute monetary policy and the potential impact of their actions on the economy and the financial markets, there's one more important
point to consider. In a 2013 paper, Eugene Fama, the father of the efficient
market hypothesis, demonstrated that the Federal
Reserve's target interest rate does not appear to affect
long-term interest rates. And there is a substantial
amount of uncertainty about whether or not the fed
short-term interest rates. In other words, Fama's suggestion is that the Fed's actions may
have much less of an impact than many people believe them do. The stock market and inflation
are both unpredictable. Central bank actions are
only one of the many reasons that this is true, if they
have any impact at all. Fixating on the central bank's actions and allowing them to influence
your investment decisions would be a mistake. Long-term, only a cross
section of the companies around the world, through
low cost index funds is the most sensible approach to dealing with the unpredictable
nature of stock markets in the short term. If you want to learn
more about this topic, I highly recommend the books, "Pragmatic Capitalism," by Cullen Roche, and, "Economics for
Everyone," by Jim Stanford. Both of which give clear and accurate operational descriptions of the way that money works within a modern capitalist economy. Thanks for watching. My name is Ben Felix of PWL Capital, and this is, "Common Sense Investing." If you enjoyed this video,
please share it with someone that you think could benefit
from the information. And don't forget, if you've run out of "Common Sense
Investing" videos to watch, you can tune into weekly episodes of the "Rational Reminder" podcast wherever you get your podcasts. (upbeat music)
Note: I don't agree with the conclusion of the video that QE does not result in 'inflation' which is self contradictory. Lowering long term rates and increasing asset prices will result in inflation - but in the future.
He also mention that banks, can't lend out bank reserves, however central bank reserves are essentially an asset in the banks balance sheet that can provide liquidity between banks allowing them to loan out more credit without needing to borrow in the overnight markets.
So If I counterfeit 1 trillion and swap it for government Bonds there’s no net inflationary impact? That’s ludicrous. Any transaction is a swap. There’s now +1 trillion extra demand for government bonds and you would expect the yield to drop and spillover into assetsprices. Watch the tears when when the FED will try to unwind their balance sheet
Reserve requirement was only lowered to zero 5 month ago, before that we had fractional reserve banking
Some points from the video (with only minor embellishment):
It sounds like the Fed is practically useless as an institution. And if you think about it, this makes sense. Why would a group of bankers be able to predict what the economy needs better than the participants in the economy itself? And if people aren't borrowing money because there aren't profitable enough opportunities, the solution shouldn't be to lower the bar until people are willing to borrow money, because that will only increase bad investments and prolong an unhealthy economy.
This video seems to be saying that inflation doesn't exist at all. If inflation doesn't come from those that literally create money, where does it come from?
The video made a big deal on central bank open market operations and QE not affecting the net balance sheet of banks. However, this I think is where the video goes wrong. While on paper, yes whatever the Fed buys from the banks is worth exactly as much as paid, in reality that parity is an illusion. In a bad economy when asset prices are starting to decrease, this could generally be considered a correction towards prices that are more aligned with their fundamentals. However, as these assets are bought up, the price of those assets is artificially inflated, allowing the banks selling the assets (whether that be to the central bank, or to unlucky third parties) to make money off the artificially high prices. One might consider a central bank plus its member banks to be a pump and dump cabal on a long timescale, where the economy is pumped up as high as it can go, then dumped all at once.
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