ECON430-Topic #2: Fed's QE2

Many economists surveyed by CNBC believe the Fed will start quantitative easing again later this year. The expected amount of QE is around another half a trillion dollars at or around the time unemployment rises again. It is also expected that unemployment will rise again to around 10.0%. Dissent within the Fed on further QE has many concerned that the Fed is not being clear about their goals and plans. The fear of deflation is almost as high as the fear of runaway inflation. You might take a quick look at the monetary aggregates to get a better picture of what has happened since the Fed stopped QE1 back in March 2010.

Quantitative easing first took the form of the Fed buying long-term Fannie and Freddie debt that was of high quality. As some of this debt expires, the Fed is now planning on rolling the debt over into U.S. Treasuries, which is really a substantial difference from holding debt that is “implicitly” backed by the government like Fannie or Freddie debt. Some believe however that the news of rising unemployment (which is expected this week) will lead to a bleaker outlook for QE2. A good jobs report might dim the prospect of further easing by the Fed, which could weaken any positive effect to be gained from a good jobs report. Quantitative easing in any sense is a new policy for the Federal Reserve, and some central bankers believe that the use of QE at all is undermining the Fed’s ability to manage inflation. However, the effect of QE might already be priced into the yield curve, meaning that further QE is expected. Seeking Alpha is a popular blog that has predicted some outcomes of QE2.

Questions you might answer:

  • Do you believe that the Fed should continue pursuing a policy of Quantitative Easing? Do you believe QE2 should follow the form that is described in these articles?
  • Do you believe there is more danger in action or inaction by the Fed with regard to deflation?
  • Do you believe that inflation or deflation is a bigger concern?
  • Is there anything that concerns you about the yield curve or the monetary aggregates in general.

Please don’t try to answer all these questions, and if you would like to discuss something else related to QE2 and the articles given here, please feel free.

16 thoughts on “ECON430-Topic #2: Fed's QE2”

  1. Considering inflation and deflation, it is really a situation of determining the lesser of two evils. While extensive inflation is bad, deflation is worse [1]. We would want greater $ growth than GDP growth, because a little inflation is better than any deflation. Adopting a monetarism approach, tomorrow’s inflation will be whatever yesterday’s inflation was [2]. I don’t believe activist policy such as quantitative easing (QE) should be taken. Hopefully, the job report that comes out later this week mentioned in the Wall Street Journal article is positive.
    Because QE is such a risky strategy, couldn’t it set off something that people do not seem to even be discussing the possibility of at this point? Hyperinflation. A lot of what is discussed in class has no proven answer. What’s to say the government actually knows how much money to create through their asset swapping [3]? There is the risk of taking QE too far, weakening the value of the dollar so much. Those who rely heavily on savings (retirees) will put them in a lot of trouble considering the low interest rates and current issues with Social Security. QE is a very precarious tool that the FED is currently manipulating considering the current status of our economy and must be careful to put the national economy into an even further hole.

    [1] http://www.economist.com/node/13610845?story
    [2] Lecture 2
    [3] http://seekingalpha.com/article/227763-quantitative-easing-possible-outcomes

  2. I agree with Riley in the sense that deflation is worse than inflation, however as he mentioned above the possibility of hyperinflation is much worse than deflation. Hyperinflation can be seen as the rapid increase in prices relative to the decrease in value on a currency. If this happened the U.S. would not be able to repay any of its debts owed to other countries such as China. The thought of “run-away” hyperinflation is terrifying because of its affects not only on the U.S. economy but the world economy. The Fed should discontinue there activist policies and let the market run its course. If they continue to undergo QE policies the money supply will become too large and lead to a huge correction in the form of the devaluation of the dollar.

  3. The purpose of further quantitative easing by the fed would be to decrease long term borrowing rates and to inject liquidity into the economy. The issue is, at this time, long term interest rates are already extremely low and banks are not liquidity constrained. Banks are simply not lending in the current financial environment, and another round of quantitative easing doesn’t necessarily address the issue that banks are struggling to find viable lending opportunities. Increasing the money supply right now will not have as positive an effect that it did in the midst of the financial crisis. There is also the possibility that long term interest rates could increase because of quantitative easing. Over time, investors may price in the expected effects of inflation from the increase in the money supply (1). Without further incentivizing commercial banks to expand their balance sheets, increasing the money supply will not be enough to have a major positive impact on the economy.

    http://www.rooseveltinvestments.com/september-20-2010-thoughts-quantitative-easing

  4. I agree that both inflation and deflation are major problems. But deflation is far worse, if we are to see any returns to growth in the economy; we need to steer away from deflation in order to pay off our debt. If the value of our currency rises, it will make economic growth an issue. If the Fed needs to buff up its balance sheet by up to half a trillion dollars to stop deflation and promote confidence in the economy then it should be done.

    On this note, the risk of deflation is stronger than ever, the collapse of “credit bubble” has escalated faster than the U.S. Government can re-inflate economy [1]. High unemployment combined with low consumer spending has created an environment for deflation spiral. An active policy of creating money will like increase consumer spending especially around November, just before the holidays.

    An interesting article on WSJ [2], stated that a main cause of unemployment has to the fall of consumer demand. Employers have become pickier, and have taken a lot longer to fill vacancies. Jeff Joerres CEO of Manpower Inc, a staffing firm, stated even presented with the right candidate, firms are hesitant to hire them right away. If the Fed’s main goal of QE is to pick up consumer spending, it should be done.

    [1] http://www.foxbusiness.com/personal-finance/2010/09/23/deflation-real/
    [2]http://online.wsj.com/article/SB10001424052748703927504575540491410169152.html?mod=WSJ_hpp_LEFTTopStories

  5. Based on the expectations from the market it seems unlikely that the fed will not perform any quantitative easing. The expectations for the size of the fed’s balance sheet range from $1 to $3 trillion, up from $800 million currently. Meaning that if the fed takes no action to expand its balance sheet there will be deflation. The fed has made it clear that it will not allow any inflation to occur, especially in this economic environment. The question that needs to be figured out isn’t whether there should be any quantitative easing, but how much. No one really knows exactly where in the $1 to $3 trillion range the fed will end up. I think that we should certainly try and maintain a healthy rate of inflation to try and boost the economy out of the employment slump we are currently in. Meaning that the fed should aim closer to the $3 range of quantitative easing and hope that the lowered interest rates will boost output. Also, because interest rates are already so low there is little chance that they could fall dramatically based on a large amount of quantitative easing and have cause too much inflation.

    http://www.cnbc.com/id/39375217

  6. After reading through the various articles linked above, I do think the Fed should continue pursuing a policy of quantitative easing. One of the issues that are still keeping our economy from recovering completely is that people are afraid to spend money, and are therefore hoarding it in savings. This is money that is just sitting there and not stimulating our economy the way it could be if people were confident that the crisis was permanently behind us. This is one of the things that QE2 is trying to help with, and by increasing money supply it should promote inflation. A consistent rate of inflation would discourage people from just “sitting on their money” and spend it, because otherwise their money would be losing value due to inflation whereas a tangible asset would not. I also think that deflation is a much bigger concern because it could discourage foreign investment and therefore hinder our economy even more. Our government can’t just sit back and wait to see what happens, and I think that attempting to influence inflation now is easier than waiting to see if it gets way worse later and then trying to react.

  7. We have now seen the new jobs report and it was not good news. Investors are already expecting the Fed to initiate quantitative easing of as much as 100 billion dollars per month. All the while, the Fed is trying to manage expectations by going back and forth on positions. I don’t think uncertainty in the market is good, and either way, I don’t think investors are buying it. At this point I would say that QE2 is already priced in or in the process of being priced in. This can easily been seen by looking at the dollar. The dollar steeply declined as a result of people expecting the Fed to insert large amounts of cash into the system. I think that promoting inflation and preventing deflation should be a priority right now but I don’t think that QE2 will effective in doing so. Banks are sitting on liquidity, not lending. Even if they did start lending again, I’m not sure that more credit in the system is the solution to the country’s economic woes.

  8. The most pressing concern with continued quantitative easing is the precedent it sets and the way it shapes expectations. As we can see from the Fed’s own report, M2 has exploded over the last 4 years, yet inflation has remained historically low. I believe much of the fear of deflation stem from fears that the Fed will mis-time its monetary contraction. Investors know the size of M2 has increased by almost a third over four years, yet the inflation theory predicts has not happened. Given the Fed’s contradictory mission; low stable inflation and full employment (1), once inflation arrives, no matter what condition of unemployment the Federal Reserve may be forced to contract the money supply. By announcing continued QE, the Fed is also changing expectations for deflation. Scott Grannis has an excellent point that a moderate amount of inflation reduces hoarding (2). Much of the ineffectiveness of QE1 can be attributed to hoarding. I expect the Fed to continue quantitative easing until inflation approaches a target level (3%?) at which time they will switch to an inflation fighting policy.
    P.S. I also had a great though that the Fed is playing a giant shell game, talking up QE2 to stoke inflationary fears and mobilize excess reserves without having to make any overt action that might spook consumer confidence, as news of deflation fighting policies most certainly would.
    1) http://www.federalreserve.gov/aboutthefed/mission.htm
    2) http://seekingalpha.com/article/227763-quantitative-easing-possible-outcomes

  9. “We need the liquidity, we need the oil to pump the engine,” (JMU’s Dr. Elwood). Right now that is what the Chicago Fed President Charles Evans has just called out in his criticism to the Fed. While many see that the Fed is calling for a policy of quantitative easing there are many doubts surfacing about it being a success. QE is a policy by the Fed with the goal of increasing the money supply by increasing excess reserves in the system when normal methods (discount and federal funds rate adjustments) are not viable options. The problem that Mr. Evans is seeing is what he calls a “liquidity trap.” This exists when banks don’t lend and firms don’t invest at the scale we need for a thriving economy. The slacking pace to drop unemployment is being targeted the wrong way according to the Chicago Fed President. A concentration by the Fed needs to be on driving down real interest rates and not just nominal rates which ignore inflation. Perhaps to do this effectively the Fed could raise their target inflation rate for a period of time and allow these rates to return to normal levels.

    http://online.wsj.com/article/SB10001424052748703843804575534043689519572.html?mod=djemalertNEWS

  10. Is quantitative easing the most productive way of stopping the threat of deflation in the American economy? The Federal Reserve is in a panic over the threat of deflation occurring, so the Federal Reserve is responding by increasing money supply to change the perception of the American public. The government needs to stop intervening with the economy. Quantitative easing is effective in the short term but it proves to have detrimental effects in the long term. By increasing liquidity, inflation occurs, which causes a lack of confidence in investment. Foreign investors will most likely choose not to keep their money in the American economy because of the worry of losing real value of the investment.
    The economy goes through highs and lows but in the long term fixes itself. By the government intervening in the economy, the public faces substandard effects, leaving American citizens worse off than if the intervention never took place. History repeats itself and one can see the negative effects that occurred from the increase of money supply in the 1970’s; the 1980’s were faced with a heinous downturn of economic events. The Federal Reserve needs to allow the economy to fix itself even though it could take years to do so.

    http://genuineforextrading.com/32348/understanding-quantitative-easing-and-its-effects-on-the-u-s-economy-and-the-u-s-dollar-part-2.htm

  11. I think we need to take into account policy moves by other central banks and general market perception. Japan added over $100 trillion in liquidity injection to thwart threat a currency surge has on the country’s economic growth. In addition to that, BoJ took a tough stance and stated that it would take any additional steps necessary to eliminate these threats. England last month has embarked on a fresh round of stimulus spending to keep rates on the gilt low [2]. Not to make the argument that the U.S hasn’t been taking enough steps in curbing the economic slowdown, for the fed to not be certain of their future move is a bad sign. We are already deeply embedded in this policy, and at this point all the fed can do is keep at it. Bernanke need to portray a confident persona to the market and keep investor sentiment afloat and hungry for U.S debt. After all, on Wall Street there is already a sentiment that the U.S economy will lag behind other countries in the recovery [1].

    Bibliography:
    [1] http://www.bloomberg.com/news/2010-10-03/world-economy-decoupling-from-u-s-in-slowdown-returns-as-wall-street-view.html
    [2] http://www.businessweek.com/news/2010-08-30/boj-boosts-loan-program-pledges-more-steps-if-needed.html
    [3] http://www.guardian.co.uk/business/2010/sep/22/bank-of-england-stimulus-measures

  12. @mark

    I never thought of it that way, if the Fed announces there going to print more money, consumers will be forced to spend in order to have the same value of their money. The one question I wonder is whether QE will spark a increase in prices as a direct cause of the Fed’s action. If people are expecting the government to print more money, are domestic prices going to sky rocket? So could the Fed say that they are going to participate in QE, but in the end not do it all?

  13. From the articles, I find that the timing of the QEII is probably one of the more interesting ideas. The fact that the Fed has decided to start the second easing process now, only a month and a half before this year’s holiday shopping is intriguing. Two years ago the holiday shopping season was terrible, one of the worst years in memory; yet last year it was much better and there was positive growth. Now this year with many believing that we are economically better off than last year and way better than two years ago, I am surprised that the fed does not wait until after the shopping season to decide on QEII. I believe that the fed would better off announcing that there would be no QEII and waiting for the holiday season to pass, we would have a better understanding of where the economy is. I do see how this can back fire, if the holiday season turns out to be more like the bust of 2008 than 2009. But from the readings and other news information I do not see this happening, as long as the Fed states that it will not pursue QEII and will stand by its statement. I still believe that the public will see QEII as of a more negative than positive and begin to hoard instead of spend in the biggest spending time of the year.

  14. I suppose it could be debated that the Fed is already doing more QE than it had previously signaled it had intended to perform. By reinvesting principal payments into longer term Treasuries, the Fed is saying it wants to keep the current amount of reserves in the system while it tries to bring down the long end of the yield curve. The Fed needs to carefully consider all of its policy options before it goes and injects another half a billion to a billion dollars of reserves into the system. The base is already fluctuating around two trillion dollars, up from 800 billion in 2007 [1]. Monetary economics is anything but an exact science, and no one really knows how the Fed is going to get these securities off their balance sheets without disrupting the marketplace.

    Helicopter Ben Bernanke addressed this in his speech at the Federal Reserve Bank of Kansas City’s Economic Symposium in Jackson Hole, Wyoming on August 27 of this year. In the section entitled “Policy Options for Further Easing,” he mentions that additional aggressive QE policy could shake the faith of market participants to smoothly unload these securities, which he believes could lead to an increase in inflation expectations. Ben then stressed that the FOMC would need to provide “maximum clarity to the public about the methods by which the FOMC will exit its highly accommodative policy”[2].

    While I agree that uncertainties over the eventual wind-down could spur expected inflation, I think the greater worry is that of the deflation that could occur when we start selling off securities. The Fed has never done anything like this before. If the Fed starts selling off its securities, bidding down prices and driving up rates, I think some really bad things could happen. A collapse in bond prices (the bursting of a bond bubble?) could create a tremendous negative wealth effect which could stymie or seriously curtail investment and consumption. America’s aging population would be especially vulnerable to this, arising from adherence to simple investing rules for allocating one’s portfolio between equities and bonds (rule of 100, 110, etc).

    Pumping more reserves into the system just means that the Fed will have more securities to dump in the market down the road. If they have a greater amount of securities to unload, then I imagine they will have to drive bond prices even lower to entice banks to purchase the desired amount of securities. QE2 will only complicate an already complicated and unpredictable wind-down in the future. Instead of pumping reserves into a banking system facing serious capital constraints, the Fed should stay committed to keeping inflation expectations grounded while keeping the public informed as to its policies concerning the use of non-traditional tools.

    http://research.stlouisfed.org/fred2/series/BASE?cid=124 [1]

    http://www.federalreserve.gov/newsevents/speech/bernanke20100827a.pdf [2]

  15. In all of there press releases the Fed has alluded to purchasing “long-term securities,” but what securities does the market actually think they will purchase? Normally when you talk about financial instruments, long-term securities are securities with a maturity greater than 1-year, so this technically means that the Fed can buy anything from 1-year bonds to 30-year notes, but which part of the curve should it focus on? According to Pimco’s Bill Gross and other investors, 2-, 3-, and 4-year treasury yields cannot go much lower than they already are (1). For example, the 2-year yields about 37bps, when over night lending rates are 0-25 bps. Additionally, in the back end of the curve, 10- to 30-year bonds are already pricing in inflation expectations and they cannot move those yields much lower either (2). Therefore, the optimal securities the Fed should be targeting are ones with 4-, 5-, and 7-year maturities.

    (1) http://www.bloomberg.com/video/63583858/
    (2) http://seekingalpha.com/article/227763-quantitative-easing-possible-outcomes

  16. Concerning quantitative easing, the underlying issues that prompted QE1 are fundamentally different than the issues the economy is undergoing now. QE1 was implemented to help credit strained commercial banks. However, as Will pointed out, banks are no longer liquidity strained (1). They simply are not making loans. Therefore attempting to bolster the economy by pursuing a second policy of quantitative easing would prove to be largely ineffective. Another immense issue with a second quantitative easing policy is that in theory it would drive up asset prices (specifically long-term asset prices) which could lead to asset price bubbles – which, at least partially, led to the most recent financial melt-down (2).

    (1) http://pragcap.com/northern-trust-qe1-failed-why-will-qe2-work
    (2) http://seekingalpha.com/article/227763-quantitative-easing-possible-outcomes

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