- 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.
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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.
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