THE quantitative easing mechanism
Fluctuations in energy prices, while not directly reflected in the core index, do usually spill over into the other sectors of the economy with some delay. The recovery of oil prices since Q1 2016 may therefore exert slight upward pressure in 2017. Similarly, inflation expectations (as measured in surveys and market instruments) were, in recent quarters, mostly aligned with headline inflation and therefore the base effects of energy prices. Although logically they should be expected to gradually ease starting in Q2, it will probably not occur without slightly contaminating core inflation, including through wages.
Lastly, the currency fluctuations seen in 2016 could also leave their mark. While it is true that the euro has slightly fallen against the dollar recently, its effective exchange rate continued to rise over the past four quarters due to its appreciation relative to emerging currencies and, to a greater extent, the GBP. Because of the delay in the spillover of these currency movements to prices, their impact on inflation in the eurozone in 2017 will probably be neutral to slightly negative (provided there are no further broad movements on the foreign exchange market).
The Fed’s QE has consisted in purchases of securities (Treasuries, MBS, agency bonds) financed by central bank money created for this purpose. These securities have shown up on the asset side of the Fed’s balance sheet, while the increase in bank reserves has shown up in the Fed’s liabilities for an equivalent amount. QE has thus mechanically expanded the Fed’s balance sheet.
Did banks sell Treasuries to the Fed? If the banks had sold their own Treasuries to the Fed, their balance sheet would not have expanded, and QE’s only impact would have been a shift in the breakdown of their assets (from Treasuries to the reserves held with the Fed). However, a look at the breakdown of holdings of US Treasuries shows that US banks have been net buyers of them during QE phases. In reality, the banks, who are the only ones holding accounts with the Fed, have actually served as an intermediary. Let’s take the example of an investor who sells securities to the Fed through a bank. In this case, the investors’ transaction is first recognised in the bank’s liabilities, and the bank’s sale of securities to the Fed leads to an increase in the bank’s excess reserves in its assets and an equivalent increase in deposits in its liabilities. So QE operations have not caused just the Fed’s balance sheet to expand but also US banks’ balance sheets.
What about the reinvestment of maturing Treasuries? The Fed reinvests the amounts from maturing securities directly on the primary market with the US Treasury, without the use of intermediaries. The reinvestments are split among the Treasury auctions held the day of maturities (prorated to the volume of each of the auctions held that day).
When the Fed ultimately decides to no longer reinvest the securities it holds, other investors will take over and their bank deposits will decline, which will lead to a decline in banks’ excess reserves.