Yellen on QE2

In a speech by Janet Yellen at the Brimmer Policy Forum, Yellen gave the fed's rationale for QE2. Some interesting excerpts are below:

"As shown in figure 1, the unemployment rate rose from around 5 percent in the spring of 2008 to about 10 percent by the autumn of 2009 and has stayed well above 9 percent since then. Most observers, including myself, judge this level of unemployment to be much higher than levels consistent with full employment and stable inflation... In addition, a historically large fraction of the unemployed have been out of a job for a very long time. For example, roughly 4 percentage points of today's unemployment rate reflects individuals who have been unemployed for half a year or more. Those who experience an extended period of unemployment face a risk of losing their ability to participate successfully in the workforce, lending additional urgency to the task of reviving the demand for labor."

The high unemployment rate and low levels of capacity utilization have been the Fed's go to reason for the necessity of QE2. What surprises me is that Yellen did not cite weakness in housing markets as a reason for QE2. However, Yellen does continue on to a discussion of long term assets, which directly affect housing markets in the form of long term interest rates.

"As shown in figure 4, longer-term Treasury yields have risen substantially over the past couple of months since the FOMC initiated this round of asset purchases. I believe that this increase in Treasury yields likely reflects a number of significant factors, including incoming information suggesting a somewhat stronger economic outlook and the fiscal package that was announced by President Obama in early December and approved by the Congress about two weeks later; that package will not only support economic growth next year but will also increase the amount of federal debt issuance. Also, investors appear to have scaled back their expectations about the extent to which the FOMC will engage in further purchases beyond those already announced; however, the effect of that reassessment on market rates tends to bolster the view that the Federal Reserve's securities purchases do indeed affect yields in the direction indicated by analytical and empirical studies."

One point (that was also made by Duke) is the fact that QE2 is meant more as a way of maintaining the Fed's expansionary policy rather than furthering it. However, this speech actual cites evidence for this claim. This point is interesting, and perhaps under stated.

"In contrast, I disagree with the notion that the large quantity of reserves resulting from our asset purchases poses some special barrier to removing policy stimulus when the right time comes. The FOMC will be able to increase short-term rates by raising the interest rate that we pay on excess reserves--currently 1/4 percent. That ability will allow us to manage short-term interest rates effectively and thus to tighten policy when needed, even if bank reserves remain high."

Once again, another major player in the federal reserve system has openly stated the role of interest on reserves in keeping inflation in check. The more I read and the more I think about it, the more I am convinced that the interest of reserves policy tool will become the new tool of choice for the Fed in the period that it will take for the economy to recover. The implications for this are profound. It essentially says that the Fed will be able to keep toxic assets on its balance sheet for an extended period without lowering the effective interest rate in the economy.