Understanding Quantitative EasingTuesday, November 25th, 2008
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The Fed is currently facing a problem that is different from the one it has faced for much of the past 50 years. Since 1951 (when the Fed regained control of monetary policy from the Treasury), the Fed’s problem was managing the inflation rate; in recent months there has been some concern that prices might begin to decline and that the US might be facing a deflation. Using traditional monetary policy, the Federal Reserve uses open market operations to achieve its objectives. That is, the Fed sets a target for the Federal Funds rate and then buys and sells Treasury securities to maintain that rate (see here for a brief description of the policy tools the Fed has at its disposal)
, But the Fed cannot cut interest rates below zero to stimulate the economy, so when interest rates get low (as they are now) they use a different strategy.
Current Fed Chairman Ben Bernanke is a student of the Great Depression (see
, for example, Essays on the Great Depression) and has spent much of his career thinking about how Fed policy might operate. In a speech given in 2002, Bernanke spoke specifically about how the Fed might “cure deflation”. He wrote:
Normally, money is injected into the economy through asset purchases by the Federal Reserve. To stimulate aggregate spending when short-term interest rates have reached zero
, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system–for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult
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, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.
As noted above, during normal times the Fed can buy Treasury securities to increase the amount of money in circulation; but the Fed is not limited to just buying Treasuries. The Fed can buy other assets (”expand the menu of assets that it buys”), such as commercial paper. In the early days of central banking, these securities served the role that Treasuries serve today (see section 13.2 of the Federal Reserve Act here, which allowed the Fed to buy short-term agricultural, industrial and commercial paper).
Further, the Fed can make direct low-interest-rate loans to banks; by providing banks with low-cost funds the Fed presumably creates the conditions that banks will be willing to make low-interest-rate loans to their customers. But as we have seen in recent weeks, “calibrating the economic effects” of these measure is difficult; the Fed does not have much experience with these tools and cannot accurately estimate the effects of a given policy move (unlike open market operations, where the Fed has a very good idea of how weekly operations affect short-term interest rates and eventually the economy).
Finally, the Fed can work with the Treasury; the Treasury could issue additional securities which the Fed could then purchase, directly increasing the amount of money in circulation.
The Bank of Japan attempted quantitative easing in 2001 without much success (see here for a discussion); like much Japanese policy in recent years, policymakers seemed more concerned with stability than with ending the crisis. The current Fed and Treasury seem less concerned with stability (see Bear Stearns, Fannie Mae, Lehman, Wachovia etc.) but whether their efforts will prevent a lengthy crisis is still uncertain.