Quantitative Easing

On Wednesday we will begin talking about monetary policy. To help a struggling economy the Federal Reserve will lower interest rates by increasing the amount of money available for banks (through an increase in reserves). Remember banks are able to lend out excess reserves. The interest rate influenced by the Federal Reserve is called the federal funds rate. The federal funds rate is a short-term interest rate that is determined in the federal funds market. The federal funds market is where banks borrow and lend to other banks. A bank that needs more reserves can borrow from other banks. It's not uncommon for a bank to make to many loans and have a shortage in their reserve account. When the Federal Reserve lowers the federal funds rate they will increase the amount of excess reserves in banks, with more reserves in the banking system, banks will lower interest rates to attract more lenders. During the recent recession, the Federal Reserve has increased bank reserves by nearly $800 billion, but banks have not increased loans meaning long-term interest rates have not come down and the money supply has remained relatively unchanged. More importantly, investment has remained low.

To help encourage more borrowing, the Federal Reserve has taken steps to reduce the long-term interest rate. This process is called quantitative easing. Normally a lower short-term interest rate will lower long-term interest rates. Long-term interest rates are an average of short-term rates. Despite having short-term interest rates near zero, long-term rates remained high. Long-term interest rates were high because banks were worried about future mortgage defaults and government deficits. The solution was for the Federal Reserve to directly buy long-term debt instruments. This would reduce yields on long-term debt, which will hopefully increase borrowing.

To date the Federal Reserve has purchased $1.4 trillion in long-term debt. You can see their balance sheet here (for those interested you would want to look at reserve bank credit). This is the size of the banks balance sheet, if you look back a few years you will notice a large increase.

More shocking is this report by Goldman Sachs that says the Federal Reserve will need to purchase an additional $4 trillion in long-term debt. This behavior will create inflationary concerns.