It is often said these days that quantitative easing (QE) amounts to printing money. Right after that the word ‘hyperinflation’ pops up. But is the Fed really “printing” money. Obviously the Fed is not physically printing dollar bills. Hardly anyone claims that. What exactly are the mechanics of QE then?

Under QE the Federal Reserve is buying government bonds and mortgage-backed securities from the banks (not just from any bank but from the so-called primary dealers) and is paying in return with deposits at the Fed (in fact at one of the Reserve Banks that make up the Fed). The deposits at the Fed are created out of the thin air. Their creation is a balance sheet expansion. The Fed creates these deposits by simply making an entry into the liabilities side of its balance sheet. The deposits at the Fed are a promise to pay paper dollar bills at the request of the banks. So from this point of view one may indeed say that the creation of deposits at the Fed is very close to actually physically printing bills. In practice, of course, only a fraction of the deposits at the Fed are converted into paper money. Generally this is not necessary because the Fed knows no limits of its power to expand its balance sheet and no one doubts its ability to print money on paper.

What is more interesting is to see what this increase of reserves at the Fed means for the banks which acquire them. Banks are required (in most countries by law and in some counties by the practical necessity to service their liabilities at the moment’s notice) to hold reserves at the central bank. These reserves must correspond to a minimum fraction of the deposits at the bank (these are private deposits of the bank’s clients and they are a liability of the bank). For instance if the reserve requirement is 10% and the bank has $2 million worth of reserves at the Fed it can hold private deposits worth a maximum of $20 million. Some people erroneously consider that banks collect money from the private sector and then put that money as a deposit at the Fed. The reality is exactly the opposite. The bank must have reserves at the Fed first (corresponding to the required fraction) in order to issue private deposits (this is an approximation as in reality the bank could first expand its balance sheet by adding a private deposit and obtain the Fed deposit later, but before settling with the Fed, which is not done every day, so that allows a certain gap).

To get back to the question, what exactly is the increasing of banks reserves at the Fed doing? Well, as the banks acquire additional reserves they correspondingly obtain the potential of issuing deposits or loans to the private sector. The potential is there but in a depressed economy there might not be many willing borrowers, businesses or consumers. So there is too much supply of the potential to create credit but too little demand for it. And so the price of credit, i.e. the interest rates, goes down.

The reality now is that even with the ultra low interest rates banks are accumulating record reserves at the Fed (currently US banks have $2.5 trillion dollars of excess reserves). And that is what a big chunk of the QE ‘money’ is doing – nothing. Is it then surprising that we have not seen hyperinflation?

[Added 30 May 2015] Now to be fair it has to be mentioned that the Fed bought a lot of the assets from asset managers and money market funds. This was done indirectly through the banks. Indeed the result of these purchases was that bank’s reserves at the Fed increased. But also asset managers and money market funds ended up with deposits at banks. So QE increased the money supply.