Monday, October 18, 2010

Tutorial on Central Bank Operations with Answers to FAQs About Monetary Policy and Exchange Rates

I have been doing some blogging lately on the topics of quantitative easing and exchange rate manipulation. Looking around, especially at comments,  I can see that many bloggers, myself included, are wrongly assuming that their readers understand the basic mechanics of central bank operations. In the hope of making a small contribution to economic literacy, I have prepared a short tutorial explaining what happens when the Fed, the People's Bank of China,  or any other central bank carries out certain monetary policy operations:
  • Purchases and sales of securities, including the large-scale programs called quantitative easing
  • Intervention in foreign exchange markets
  • Sterilization of exchange rate intervention
In addition to explaining basic terms and concepts, the tutorial attempts to answer certain frequently asked questions. Here are four of those questions with answers in brief. These are real questions taken from recent comments on several blogs, edited only to combine a greater number of original questions into these four generic FAQs. The full tutorial slide show gives more complete answers, illustrated with balance sheets and T-accounts.

FAQ No. 1: What is "quantitative easing" (QE) and how does it affect the money supply?

Answer: "Quantitative easing" means large-scale purchases of securities, incuding long-term securities, by a central bank. QE is an extension of the normal day-to-day buying and selling of short-term securities, which are called open market operations.

When the Fed or another central bank buys Treasury securities, whether as part of a program of QE or otherwise, it does not buy them directly from the Treasury, but rather, from some dealer or other party in the private sector. It pays the seller by means of a bank transfer. The result of the transfer is to increase not only the seller's bank deposit, but also the reserves of the banks where the sellers hold their accounts. Those bank reserves count as part of the economy's "monetary base," which can be thought of as the raw material from which money is created.

When banks later use this raw material (their new reserves) as a basis for making new loans, total bank deposits held by the public expand further. Looking at the procedure from start to finish, then, any purchases of securities by the Fed tends to expand the money supply.

Notice the words "tends to expand." Sometimes market conditions are such that banks are reluctant to make loans. Then the new reserves that the Fed injects into the banking system just pile up on banks' balance sheets, and the effect on the money supply is much weaker. That is what seems to have been happening since the start of the financial crisis. For that reason, among others, some people doubt that QE is a very effective way of stimulating the economy.

FAQ No 2: When the Fed buys Treasury bonds, does it lift the burden of interest costs from the shoulders of taxpayers? Does that mean there is, after all, such a thing as a free lunch?

When the Fed buys Treasury securities, the Treasury keeps right on making interest payments. The interest now becomes a source of income for the Fed. In contrast to an ordinary commercial bank, however, the Fed is not allowed to make a profit when its interest income goes up. Instead, after deducting its operating costs, it turns any surplus back to the Treasury. In that sense it is true that there is no interest burden on the taxpayer, and the government is getting a sort of free lunch, at least in the short term.  However, there are two important qualifications to the free lunch concept.

First, since October 2008, the Fed has had the power to pay interest on bank reserves, and does so. Because purchases of Treasury securities add to bank reserves, they also add to the Fed's interest costs. As a result, part of the interest that the Treasury pays to the Fed leaks out into the banking system before it gets recycled back to the Treasury. True, the interest rate the Fed pays on bank reserves is less than the rate on long-term Treasury bonds, so there is still a net saving to taxpayers. In this sense, we might say that taxpayers are getting their lunch at a discount, even if it is not free.

Second, there are limits to how big a portfolio of Treasury bonds the Fed can accumulate. Right now, because of the financial crisis, the limit is larger than usual, so the Fed can hold a lot of bonds, but that situation cannot be expected to last forever. Sooner or later, the economy will recover and banks will become more aggressive about making loans. At that point the Fed will have to sell off a large part of its holdings of bonds in order to keep the money supply from growing too fast and causing unwanted inflation. When that happens, the free lunch is over and the interest burden shifts back to the taxpayer.

FAQ No 3: Why do the Chinese central bank's efforts to manipulate the value of the yuan cause inflationary pressures in China?

China's huge trade surpluses create a constant flow of dollars into China. The big supply  tends to push down the value of the dollar and, correspondingly, causes yuan to rise in value (appreciate). If the Peoples Bank of China (PBoC) wants to keep that from happening, it jumps into the foreign exchange market itself. To mop up some of the excess supply of dollars, it buys dollars from the various private forex dealers that are acting on behalf of the ultimate suppliers--companies that import Chinese goods to the US.  The dollars the PBoC buys are used to acquire U.S. Treasury securities, adding to China's ever-growing foreign currency reserves.

When the PBoC buys dollars from private dealers, it pays in yuan. Those yuan end up in the bank accounts of the dealers, and eventually in the accounts of Chinese companies that are exporting goods to the US. The end result is an increase in the Chinese money supply. If the PBoC intervenes too often and too aggressively in the foreign exchange market, the Chinese money supply starts to grow faster than the country's expanding economy can safely absorb. Ultimately, the excess supply of yuan pushes up China's rate of inflation.

FAQ No. 4: If currency manipulation by the PBoC causes inflation, why hasn't China's inflation rate been a lot faster?

The PBoC has another policy instrument in its toolkit that we haven't mentioned yet. If its foreign exchange intervention threatens to cause inflation, it can mop up at least some of the excess yuan by selling its own securities, which are called PBoC bills. The PBoC bills, which do not count as part of the monetary base or money supply, replace bank reserves, which do count. This operation--the swap of PBoC bills for yuan-denominated bank reserves--is called "sterilization."

Sterilization looks like a kind of free lunch for the PBoC--it lets it resist unwanted appreciation of the yuan without paying the inflationary price of doing so. But like all apparent free lunches, this one is not quite as good a deal as it looks at first. After a while, the market becomes saturated with PBoC bills. The bank has to offer higher and higher interest rates to sell them. That would not only create a potentially enormous interest expense, it would push up interest rates throughout the Chinese financial system, slowing investment and growth. Because the PBoC exercises great administrative authority over Chinese banks, it can pressure them to absorb a lot of bills at low interest rates, but that tactic has its limits, too. Eventually the unwanted PBoC bills start to clog up the banking system and prevent it from operating efficiently. 

Although no one outside China really understands the internal politics behind the government's exchange rate manipulation, there are hints that the PBoC would just as soon allow a little more appreciation of the yuan in order to ease inflationary pressures. Presumably there are interests on the other side, including China's huge export industry, that use their political influence to resist appreciation. Outsiders can only guess how this will all play out.

Follow this link to download the complete tutorial in the form of a classroom-ready slide show.


  1. Good stuff sir!

    Thank you for making it easy for this dunce to understand...

  2. Mr. Dolan,
    Thank you very much for this Q&A. It helps to clean up a lot of what the mainstream media has been unable to clarify. I'm an econ student and I've talked to students and professors about this but none of them seem to be able to answer any of my questions regarding QE and PBoC. Thank you!

  3. Glad you found it useful. Don't forget to recommend it to your professors!


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