Quantitative Easing – The Fed’s Ammunition

Quantitative Easing ﴾QE﴿ Round 2 has just come and gone. Essentially, QE has added to what would soon be US$ 2.4 trillion of non‐interest bearing cash and bank reserves. Just recently, Federal Reserve Chairman Ben Bernanke spoke against the possibility of a third round of quantitative easing. It would be a good point in time to reckon the merits QE brought and also surface some faults in this policy. This article will not seek to debate about the policy, but to discuss some of the intentions of Federal Reserve’s action of implementing such drastic steps as means of boosting economic recovery, and also the trade‐offs in these actions.

First, a historical understanding of QE is required. This concept dates back to 2001 whereby the Bank of Japan ﴾BOJ﴿ unsuccessfully used it to fight domestic deflation in the early 2000s. In the wake of continued weakness in the Japanese economy and recent market turbulence due to the terrorist attacks in the US, the BOJ initially switched from the usual approach to expansionary monetary policy such as a reduction in the target short‐term interest rate to quantitative easing because by that time it had been pursuing a target very close to zero ﴾0.15%﴿ since 1999. The BOJ argued that, at an interest rate so close to zero, further nominal interest rate target reductions were constrained to be small, as under normal circumstances nominal interest rates are bounded at zero. As a result, the possible stimulus obtained through further reduction in the interest rate target was likely to be limited. With quantitative easing, it flooded commercial banks with excess liquidity to promote private lending, leaving them with large stocks of excess reserves, and therefore little risk of a liquidity shortage. The BOJ accomplished this by engaging in open market transactions aimed at increasing its balance of current bank accounts held at the BOJ, through the buying of more government bonds than would be required to set the interest rate to zero. It also bought asset‐backed securities and equities, and extended the terms of its commercial paper purchasing operation.

It should be clear, by now, that the Federal Reserve aims to boost economic recovery via stimulating expenditure. To do this, QE is indeed a good option because the first effect of QE would be to immediately drive the interest rate on near‐substitutes of cash such as Treasury bills ﴾T‐bills﴿ to nearly zero where we will assume that the interest rate for cash is close to zero. This happens because any significant positive interest rate would induce people to try to shift their holdings from non‐interest bearing cash to Tbills and they bid up T‐bills to the point where they are indifferent between the two. Eventually, all the T‐bills that have been issued are held and all the cash is held, reaching equilibrium such that both are now equally unattractive. As a result, people tend to avoid savings and this can be seen by the declining personal savings rate by a full percentage point from 6.3% in the spring of 2010 to 5.3% in December 2010. However, it is only in theory that the Federal Reserve is buying Treasury securities and creating currency and bank reserves to pay for them. This process of QE, in reality, would simply be an asset swap were it not for the fact that the US is running a budget deficit of about 10% of GDP, so its purchases would not even absorb the amount of newly issued Treasury debt. Thus, the overall effect of QE is to reduce the amount of debt that the public would otherwise have to buy, and to instead create money and bank reserves to indirectly finance government spending.

Also, the factor of unemployment, an indicator of economic recovery, has not been and will not be addressed by QE. The unemployment rate had been reported to have fallen by a percentage point. It is probably not that there’s been an anaemic growth in jobs but instead, more people are being statistically kicked out of the labour force altogether. Even if we accept the Bureau of Labour Statistics’ numbers, unemployment has gone down by a mere 1% at the cost of $600 billion in Fed moneyprinting, considering only Round 2. So, QE possibly did little to help in reducing unemployment to begin with. You might be wondering where the money went.

QE also has had the effect of spreading inflation throughout the world partly responsible of the accompanying political destabilization that that inevitably entails, as can been seen from the social unrest that plagued the Middle East just this year. Also, easy credit has generally been seen to land in Asia, fuelling the bubbles that forced various strict measures by Asian governments to prevent the inflow of money. The Federal Reserve would obviously not foresee how QE would export inflation and affect the rest of the world — that’s not their aim anyway.

However, they did predict that it could stimulate the U.S. economy into growth by leading a wave of business borrowing, and an expansion of the U.S. economy. They do need to watch out for inflation in their own country too.

All in all, the QE policy adopted by the Federal Reserve seems more like the best possible measure to be implemented at that point in time, considering that it is a monetary policy tool used by central banks to stimulate their national economies when conventional monetary policy has become ineffective. However, it sounded like a horrible bargain that Ben Bernanke paid $600 billion for a 1% drop in unemployment in the United States and a big inflation spike in the rest of the world, with the latter being less in their interest. Well, they stopped it ï´¾QE3ï´¿ for now; we shall wait and see.

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