Thu, Oct 28, 2010, 1:18PM EDT - U.S. Markets close in 2 hrs 42 mins
The prospect of quantitative easing -- the purchase by central banks of securities to expand the quantity of reserves -- now dominates the financial markets. Fed watchers expect the formal announcement to come at the close of the November 3 meeting of the FOMC, making this one of the most watched meetings in many months. On Wednesday, markets are having a negative reaction to a Wall Street Journal report that Fed easing may not be quite as aggressive as originally expected.
But what exactly is quantitative easing, and what is the likelihood the Fed is going to act?
The term "quantitative easing", or QE, refers to an increase in bank reserves engineered by the central bank. Actually all easing by central banks involves the purchase of assets, mostly government securities, and the crediting of reserve accounts of banks that sold those securities to the central bank.
But usually the path by which the central bank influences the economy is through interest rates, and the creation of reserves lowers interest rates in the short-term credit markets, particularly the market for reserves, called the Fed Funds market. However, by December 2008, the Federal Reserve had created sufficient reserves to send the Fed Funds rate down to zero, the lowest level it can go. Once that level is attained, further easing by the Fed only increase increases reserves and has no further impact on short-term interest rates. Therefore QE refers to a policy of increasing reserves when short-term interest rates are at or near zero.
Not the Fed's First QE
The Federal Reserve already engaged in quantitative easing immediately after the fall of Lehman Brothers in September 2008. Over the next three months our central bank created over one trillion dollars' worth of reserves, mostly by loaning banks reserves against their collateral and then directly through the purchase of mortgage-backed securities.
These reserves were voluntarily held by banks in excess of their legal requirements, even though these reserves pay a mere 0.25% interest. These excess reserves were held because banks wanted to show both regulators and their investors that they had sufficient liquid assets to cover potential loan losses or any other liquidity needs.
The creation of these excess reserves at the end of 2008, often called QE1, was critical to stabilizing the banking system. These additional reserves made it unnecessary for banks to call in loans (both good and bad) in order to restore their liquidity.
Bernanke took this action because he had learned from the mistakes made by central banks in the 1930s. The Federal Reserve did not provide excess reserves during the banking crisis, and that was the principal reason for the collapse of our banking system that brought on the Great Depression.
QE2
Since April the economic data have been disappointing and the recovery has faltered. The Fed has been under pressure to engage in another quantitative easing: QE2.
Bernanke opened the door for QE2 at his speech at the annual gathering of Fed officials at Jackson Hole this past August. He was careful to note that QE was not a proven remedy. In contrast to the Fed's control of the Fed funds rate, which has a 60-year history, the experience with QE has been limited. (See my August 17 column, The Fed is Not Out of Silver Bullets, for a more detailed description).
And the support for QE is by no means unanimous. Charles Plosser, President of the Federal Reserve Bank of Philadelphia, as well as Thomas Hoenig of the Kansas City Fed, who has dissented with Bernanke throughout this year, have expressed strong doubts. Opponents of QE2 note that, if banks are not willing to lend with a trillion dollar of excess reserves, why would they lend with, say, $2 trillion?
Supporters of QE2 claim that the first trillion dollars was used to cover loan losses and the increased desire for liquidity. This does not mean that banks want to hold more reserves. They cannot be happy receiving a mere quarter of one percent on these reserve balances when margins on other types of lending are far higher.
Similarly, many investors hold very large quantities of money market funds, insured banks deposits, and short-term treasury securities that earn near zero interest rates. But that does not mean they are willing to hold unlimited quantities of such assets. In fact, we are already seeing investors nibble at alternative investments in search of higher yields, such as dividend-paying stocks, commodities, and even real estate.
Bernanke has been nudging the Federal Open Market Committee, which consists of the seven Fed Governors and 12 presidents of the regional Federal Reserve Banks, toward easing. The statement released at the close of the last meeting opened the door a bit wider to QE2 by stating that the Fed considers the current rate of inflation lower than its target and inconsistent with the Fed's mandate to maintain high employment.
As the weak economic data have continued to mount, the expectations that the Fed will engage in QE has been mounting sharply. In anticipation of Fed purchases, the price of U.S. Treasury bonds has soared, and as a result their yields have collapsed.
In my view, these market movements are excessive, even if the Fed does undertake QE2. Recall that the intention of QE2 is to stimulate the economy. If that occurs, there is no way that long-term interest rates will stay as low as they are now. First, the Fed is likely to begin with small purchases, say $100 billion, which is about 1% of the nearly $10 trillion Treasury market. Furthermore, as QE sparks an economic recovery, private loan demand, which has collapsed during the recession, will increase, invariably leading to higher interest rates. It seems certain that the Treasury bond market seems headed for a fall.
Final Words
The U.S. economy will recover from the recession whether or not the Fed engages in QE2. But doing so will speed up the recovery. The very fact the markets have factored QE into financial and commodity prices means that there is a very high probability that the Fed will in fact act. It has long been an unwritten rule that the Fed should not shock the markets. If QE2 were not a sure deal, Bernanke would have let the markets know. His silence indicates that Fed action is near.
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