This article explains why quantitative easing had become the monetary tool of choice for the Federal Reserve and what kind of easing the Fed is now employing. Because the Fed feels constrained politically, it is unlikely to repeat ‘quantitative’ easing and will now ease through other means. Its most recent easing has already begun.
Traditional Monetary Policy Explained
Traditionally, monetary policy in the United States has focused on interest rates. If the economy is struggling, the Federal Reserve will lower its target rate, the Fed Funds rate, in order to stimulate economic activity.
For example, Bruce Bartlett, a Reagan-era policy advisor, tells us this was a major plank of the economic policy when the United States fought an economic crisis as Ronald Reagan came to office:
In 1979, the Fed began targeting the money supply, which brought on a recession in 1980. But inflation only fell to 12.5 percent. Continued tight money led to another recession in 1981 and 1982, which brought inflation down to 8.9 percent in 1981 and 3.8 percent in both 1982 and 1983. Ironically, this much more rapid improvement in inflation contributed heavily to the budgetary cost of the Reagan tax cut. Since taxes are assessed on nominal incomes and tax indexing didn’t start until 1985, the sharp fall of inflation shrank the tax base and increased the tax cut’s revenue loss.
The collapse of inflation also meant that real interest rates were extremely high. In early 1982, the federal funds rate was more than 14 percent, leaving a great deal of room for easing monetary policy. By the end of 1982, the fed funds rate was down to 9 percent. Thus the economic expansion of the 1980s was powered by a combination of tax cuts, falling inflation and lower interest rates.
The Advent of Unconventional Policy
The Fed Funds rate is effectively zero percent. So, cutting interest rates has not been an option available for Fed policy since 2008. Therefore, the Federal Reserve has turned to quantitative easing in order to provide monetary stimulus. In June, I explained the differences between QE1, QE2 and a potential QE3.
the first round of large scale asset purchases by the Federal Reserve was intended to support economic activity. However, because the Fed focused on the asset side in increasing its balance sheet by buying assets it had not previously purchased in large quantities, the Federal Reserve worked to support the functioning of credit markets by providing liquidity to the private sector. Without this easing, the US and the global economy would have had a depression of indescribable severity with unknown attendant geopolitical and military consequences.
Was QE1 a bailout? Yes. But QE1 was also a legitimate lender of last resort operation. We should question the terms of QE1 i.e. "The Fed lent freely, but at a low rate, on dodgy collateral" not the operation per se.
The second round of quantitative easing was distinct from the first – and more akin to what the Japanese had done. The aim was to support economic activity in the US domestic economy. Starting in August 2010, the Federal Reserve started reinvesting principal payments from agency debt and agency mortgage-backed securities that it had acquired in QE1 in longer-term Treasury securities. By November 2010, after the 2010 mid-term elections, the FOMC decided to expand its balance sheet by $600 billion through the purchase of Treasury securities.
This is unconventional monetary policy. Each time the Fed has conducted one of these campaigns of non-traditional stimulus, there has been a vocal political opposition to it. As a result, the Fed feels constrained. As I explained last year before QE2 was officially announced,
The Fed has already spent its political capital. And if you want a reason why the Fed isn't doing anything about the renewed economic weakness despite Bernanke's famous 2002 helicopter speech, this is it. The Fed knows darn well it has spent its political capital.
So what can the Fed do? What will it do? Well, in 2010, as the economy weakened, the Fed turned to QE2. That policy ended in June. At that time I said “I am with Richard Koo. Monetary policy reflation will not work in a balance sheet recession when fiscal policy is contractionary. But at some point, the Fed will be compelled to act anyway.”
Last month, I said
the Fed will pause to assess the economy before doing anything else. If economic growth in the U.S. does not falter in the second half of 2011, the Fed will look to drain excess reserves from the system as preparation for an interest rate hike at some unforeseeable future date.
There is immense pressure on the Fed from within as well as politically to refrain from more unconventional policy.The economy will weaken significantly before the Fed moves against it – and only then because of vocal outcries for more policy stimulus.
The third round of unconventional stimulus is now starting
Since then, the economy has weakened considerably. The Fed even said so directly - “economic growth so far this year has been considerably slower than the Committee had expected”. So now the QE3 speculation has begun.
Here’s what I think is happening at the Fed. Fed doves have wanted some sort of easing. Under consideration are targeting long-maturity asset purchases, setting an interest rate target or even eventually buying municipal bonds (see What QE3 could look like from June).
Fed hawks want no part of this. Look at the three dissents at the last meeting and Kocherlakota’s statement on dissenting the Fed’s permanent zero policy. So the doves have been forced to alter QE3. Here’s how I put it last month:
The Fed is likely to soft peddle this policy change because of comments from people like former Atlanta Fed President William Ford questioning Can the Fed Go Bankrupt? The Fed will want to stay to the shorter end so as not to risk its balance sheet by moving out the curve with interest rate caps. However, there could be internal dissent, so the Fed could start off by signalling to the market that it will conduct what I have been calling 'permanent zero'. Eventually people will be forced to accept this – and the term structure will flatten further and further out the curve. That's how Japan got to a 1% 10-year yield because expectations of zero rate policy continued to lengthen in time.
This is what we just got last week, permanent zero. I believe this is the first salvo in a renewed easing campaign by the Fed. I had been saying full-blown QE3 wouldn’t begin until 2012. In fact, the permanence of the zero to which the Fed has committed is much longer than I had anticipated. I would go so far as to call this full-blown rate easing, one of the three easing policies I identified earlier as QE3 contenders. That’s why you got three dissents at the last FOMC meeting, which you will almost never see at the Fed.
The 0.375% US Treasury note maturing on 31 July 2013 is now yielding only 19 basis points. Call this financial repression, call it rate easing, call it permanent zero or whatever you want; What the Fed has just done is effectively guarantee interest rates out to two years. In essence, QE3 has already started - and that's bullish for fixed income investors because it guarantees a floor for non-credit-related fixed income investment risk. Interest-rate risk is gone for investments up to two years; Private equity and leveraged finance will need to get busy.
Watch the upcoming speeches at Jackson Hole to see how much further the Fed is willing to go.