38 Comments
Feb 25Liked by Alfonso Peccatiello (Alf)

Very concise and helpful, thank you.

However there are two significant issues to be considered and discussed :

A: if QE buys bonds from the private sector, it leads to an increase in bank deposits...inflationary bias in investment valuations (private equity etc)

B: QE increases demand for bonds and lowers yields.... inflationary bias in financial assets

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author

A. Yes, but PIMCO having more bank deposits has nothing to do with inflation. It might affect asset valuations (if PIMCO decides to take more risks)

B. Yes, if entities have more risk appetite

So in principle QE can lead to more risk taking in financial assets. Still nothing to do with inflation.

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Feb 25Liked by Alfonso Peccatiello (Alf)

Thanks Alf, I've heard you explain this on podcasts before but this is a more concise and comprehensive overview. Cheers!

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author

My pleasure!

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Feb 25Liked by Alfonso Peccatiello (Alf)

A very good explainer. Perhaps the best I have read on the topic.

To be good it has to be brief. Still, I think two details would be good to mention:

1. In your own words: "[Government] deficit spending to be ‘‘financed’’ by bond issuance, which banks can just absorb swapping reserves for bonds.". But there is also a secondary market here -at least to some extent- where banks can sell these bonds to non-banks, and get paid with real-economy money (i.e. not reserves). This must have an effect on banks' balance sheets, and -at least potentially- on the real economy.

2. Again starting with your own words: "(...) your REAL ECONOMY money printers.

Banks - when they lend aggressively to the private sector, creating new credit which can be spent."

If we translate "aggressively" into something like "more than they get paid back on existing loans" I think we have a more complete picture. It is the net debt growth that counts. Heavily influenced by new loans, yes. But also includes payments that reduce existing debt.

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author

Excellent comments! And indeed - it had to be brief.

I am working on a 5-6h course which will cover all possible angles!

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Excellent exposition. Thanks!

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author

My pleasure!

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Feb 25Liked by Alfonso Peccatiello (Alf)

Congratulations Alfonso!

I wanted to ask you a question:

I totally agree with what you said, that "financial" money printing is used to lubricate the financial system. However, what is not very clear to me is how it is possible that all this does not have any impact on inflation.

If the Central Bank can manipulate interest rates (if we look at the two-year curve), obviously people with a fixed income (employees) can afford expenses that they could not consider with higher rates.

So my question is this...

Considering that money printing for the real economy is the first real cause of inflation; can we say that the injection of financial money is totally harmless from an inflationary point of view?

See you soon and congratulations!

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author

Thanks, Marco!

There is no direct link - more financial money doesn’t increase the demand for real goods and services.

But there might be some second and third round effects as you correctly refer to.

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Perfect, i got it!

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Feb 26·edited Feb 26

if increasing demand could be a second order effect of more financial money, why claim that more financial money doesn't increase demand?

Since the market operations are structured in such a way, rarely anyone can point out first order effect of financial money on inflation.

Could you please give an example of what evidence is required to assess a first order effect of central bank printing on inflation ? (would having first order effect mean central bank printing money and giving it directly to private sector and consumers)

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It depends on what you mean by “inflation”. If this is CPI - price change measure relevant for the lower income strata of the society, the impact is likely small (though no one bothered to think what CPI would’ve been without QE). However if you look at price changes for the luxury end of goods and services spectrum: travel, higher education, high end apparel, you would see very high inflation.

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So there is some impact. Do you agree with me?

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Of course. Not for a Harvard / Yale / Princeton trained economist though.

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Alf, when you say bank reserves (financial money) cannot leak into the real economy, but you did say (indirectly) that bank reserves can improve financial system liquidity and can be used to settle interbank liabilities, I don't understand how this financial money is not indirectly leaking into the real economy. What if Bank A uses reserve money to settle a liability owed to Bank B, and Bank A had used the original interbank loan to invest in financial instruments comprising stocks, corporate debt or Government Bonds? Is that not an example of reserve money indirectly escaping into the real economy?

Please let me know if I misunderstood your original premise when I contrived the above example?

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Thank you, Alfonso! Can you explain something to me, if the central bank is paying the banks with more Bank Reserves would that drastically increase the amount of Bank Reserves for the private banks? If yes, why the banks will want more Bank Reserves?

My understanding is that the only function of a Bank Reserve is to keep the reserve ratio in the fractional reserve banking system, which is not longer necessary for the banks.

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Great Article! An environment is created where too much money is chasing not enough goods and services, in the real economy! …….Hence inflation. Got it !

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Thanks for your very clear and insightful explanations. My question is, would you say that central bank money printing redistributes wealth to the wealthy in a similar way that a limited share issue dilutes smaller shareholders?

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Everything is fine. Nothing to see here. There's not gonna be another boom - bust cycle? Because....? I understand your point, but aren't we overlooking some important things?

Don't worry about all the money printing and the quantitative easing. Who has to honor the debt, upon which we are paying interest? Aren't the taxpayers ultimately on the hook for all this reckless spending? The debt is so big it can't ever be repaid without massive devaluation of the currency. The devaluation of the currency is ongoing and significant. The financialization of the world's assets is causing the main street economy some pain, and that's going to result in unrest. The only reason we can get away with this three card monte game we are playing is that we are the reserve currency. Once the markets decide that the USA has overdone it, then there's no more buyers for the bonds and the peanut butter hits the fan. We are getting close. We have about 2-3 years more of the happy talk and then it's Argentina time. There are a number of countries around the world that understand this and will only be too happy to help drive us over the edge.

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Feb 25·edited Feb 25

Your explanation seems contradictory.

You said "Our self-imposed accounting rules require deficit spending to be ‘‘financed’’ by bond issuance, which banks can just absorb swapping reserves for bonds."

CB increases bank reserves, and banks use those reserves to buy Treasuries which finance deficit spending and real money. So, CB QE is just 1 step removed from creating real money.

Without CB QE, banks would not have reserves to finance gov't deficit spending, i.e. creating 'real money'.

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Reflecting on "Government deficits also inject new spendable money for the private sector," I have a few question/observations.

Question: What assets does the commercial banking sector use to acquire the government bonds?

BEFORE the bond purchase, banks have reserves of $100, part of which is presumably held against its deposits of $300. This suggests less than $100 is available by banks to make the $100 bond purchase. AFTER the bond purchase, banks have an additional $100 in deposits to cover with required reserves. Even if the original $100 in reserves is excess reserves, after the banks acquire the $100 in bonds, they will not be able to satisfy their reserve requirement. Hence, the question, how does the banking sector work through its bond purchase demand deposit reserve requirement? Something seems out of equilibrium.

This may not be a major issue as M1 and M2 rise by the increase in deposits and there is no expected decrease in either of these monetary aggregates.

Aside: I recognize that the article is only a partial analysis -- does not consider the secondary effects of QE, government deficit spending, etc.

For example, does not consider the effect of the Federal Reserve paying interest on bank reserves, which allows the Federal Reserve to exercise QE (buying bonds, increasing bank reserves) and effectively sterilizing a portion of the increased reserves. Where the Federal Reserve offers banks a risk-adjusted rate of return as good as or better then the private market, bankers are interested.

Aside: The article is not saying that the Central Banks have no influence over "money supply" as they clearly influence the seed corn upon which "real economy money" expands contracts.

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I´m sorry, I don´t mean to be disrespectfull but this article can be considered misleading : Central Bank money printing may not have an immediate and direct impact on the real-economy, and, subsequently in the inflation equation. BUT it does however impact INDIRECTLY and negatively the real economy and the inflation at some point in time. It will end up trickling down.

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How exactly. That's what we want to know

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Spare us the propaganda for your "Macro Fund"! Substack is not be a platform for advertorials and peddling.

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Very interesting article! You've caused a paradigm shift in my thinking!

Whenever I heard you talk about government deficit spending is creating money, I didn't agree with you, as in my mind only banks could create money. I was always thinking in 2 layers: central banks with reserves, and everyone else using deposit liabilities.

In that paradigm, government spending wouldn't print money, as it draws in reserves from the private sector (either through taxing on bond issuance), and then redistributes it. So it's more like redistribution rather than money creation.

But what I realized now, is that we should add another layer for the commercial banks. When commercial banks hold reserves but don't want to make more loans, (ie create deposits, money creation), then government deficit spending can `unlock` those reserves by `giving` bonds to the commercial banking sector for banks to create new deposits.

But I wonder if this is the main case, for it to have a meaningful impact on money creation? Because, if bonds issuance is financed by private institutions, like pension funds, then the initial bond purchase will destroy money (pension funds deposit account decreases), after which the government redistributes the `money` back into the private sector.

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Excellent breakdown!

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