Quantitative Easing

Richard DeKaser

With the interest rates it controls now as low as practically possible, and the economy still mired, the Federal Reserve is digging deeper into its toolkit. Its latest device - quantitative easing - has dramatically increased the volume of cash in the financial system and aims to increase the extension of credit. But will it work?

Before judging the efficacy of this approach, let's consider recent events. Though never officially proclaimed, quantitative easing effectively began in September. It was then that the Fed, sometimes on behalf of the Treasury, began bailing out the financial system. In addition to its usual constituency of depositories, it extended credit to investment banks, AIG, foreign central banks and domestic money market funds.

Ordinarily, the Fed would "sterilize" these loans with open market security purchases to prevent excessive cash balances at banks from driving the federal funds interest rate below its target. These weren't ordinary circumstances, however, and it was then that short-term interest rate targets took a backseat to the priority of providing liquidity.

Subsequent months witnessed a proliferation of government loan programs and the monetary base (essentially currency and precautionary balances at banks) doubled, soaring an unprecedented $900 billion. Based on new programs still being rolled out, further increases are likely.

Theoretically, there are two important ways this should stimulate the economy. First, with short-term interest rates near zero, it's hoped that some of this money will naturally go searching for superior returns in alternative assets, such as longer-term commercial paper, asset-backed and mortgage-backed securities, thereby driving down their yields and lowering the cost of credit for homeowners and businesses alike.

To encourage this, the Fed has purchased such assets directly, and the early results are encouraging. WIthin a month of announcing its plan to buy half-a-trillion dollars of mortgage-backed securities, for example, their yields fell sharply relative to less risky and shorter maturity alternatives.  Similar success (though far from complete!) is evident in the other targeted areas.

A second potential benefit of quantitative easing relates to the forthcoming fiscal stimulus and the related tsunami of federal debt issuance. If the Fed buys these Treasuries from the public (as Chairman Bernanke indicated it may), two things happen. First, the monetary base continues to climb, with the effects already noted. Second, the government is essentially borrowing for free since its debt service payments to the Fed are returned at the end of each year as surplus profit payments to the Treasury!

To good to be true? Perhaps. When taken to excess, printing money to finance government debts is a vice that is sure to create unacceptably high inflation. But if well timed and modestly indulged, at a time when inflation is contained, this occasional vice may have its virtuous moment. (1/16/09)

Richard DeKaser is the Chief Economist for National City.
Copyright 2009. All Rights Reserved.

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