My Thoughts on QE2

By now, I think that everyone has heard of the Fed's second round of Quantitative Easing. I saw the news quite a while back, but wanted to wait a bit and read more about the Fed's new move before making a judgment call regarding its policy.

I think one main point that needs to be made right off the bat is that Quantitative Easing is not all that different from traditional open market operations. The difference here is a question of magnitude, not precedence. The much coined phrase of the Fed "printing money" is flawed in that the Fed prints money any time it engages in expansionary open market purchases. The attribute that makes QE2 special is that the Fed is "printing money" to the tune of $600 billion.

It must also be noted that QE2 is not the same as the first round of quantitative easing. A large majority of the first round of quantitative easing consisted of the Fed's purchase of Mortgage Backed Securities (MBS) from the open market (MBS are not Treasury bonds, but private sector assets backed by mortgages). The purpose of such purchases was mainly to decrease the risk premium on interest rates by taking highly risky assets out of financial markets in order to stabilize said financial markets. At the same time, the expansion of the monetary base provided much needed liquidity to banks in the wake of a liquidity crisis. That is, the main purpose of QE1 was to decrease the risk profile of assets in financial markets and provide banks with relief liquidity.

So what exactly is different this time? For starters, the liquidity crisis is nowhere to be found. With a reserve boost of almost $2 trillion from the first round of QE, there is no shortage of liquidity for banks. Also, the Fed is not purchasing MBS from the private sector this time around, opting instead for long term Treasury bonds.

What does this mean? Put simply, QE2 has a completely different purpose than QE1. In the wake of recovery (most would agree that we are in recovery), one of the main factors constraining sustained growth is the housing market. Through purchases of long term treasuries, the Fed is attempting to lower the interest rate for long term assets. This will in turn make it easier for home buyers to finance a new home (and for existing home owners to refinance). In other words, the main purpose of QE2 is to give a much  needed boost to the ailing housing sector.

However, I think the main point that most economists are concerned about is the potential for inflation when the monetary base has already been expanded to epic proportions. In that regard, I believe that the Fed has more of a handle on inflation than most economists give it credit for. First of all, it is clear that despite previous expansion of the monetary base, short term inflation expectations continue to remain subdued. But even when lending begins to pick up, I believe the Fed will still be able to keep inflation in check.

The reason for this is the Fed's new tool of interest on reserves. The tool effectively allows the Fed to set a floor on interest rates. As such, should lending pick up, the Fed can simply set the interest on reserves above the Federal Funds Rate to decrease lending. Such action will prevent the somewhat excessive monetary base from translating into a change in the money supply, and by extension, an increase in the inflation rate. This policy will also prevent the reentry of risky assets into financial markets because it does not necessitate the reintroduction of risky assets on the Fed's balance sheet through open market sales, something that could pose highly problematic for an economy in strong rebound.

The verdict? I think the Fed has it under control. I really hope I'm right.