Wednesday, November 24, 2010

Quantitative Easing II

We've talked in class about QE1, the decision for the Federal Reserve to buy long-term debt instruments to lower the yield curve. Here is a nice review of the process.

Politically QE2 has drawn a lot of heat. So is it good, bad or somewhere in between.  My views tend to follow those of Greg Mankiw. I see QE2 with some potential upside by lowering interest rates on mortgages, student loans, and government debt and trying to prevent deflation. Remember we want to see inflation rates around 2%, they are still well below 1% as the economy sputters along. The skeptics point to QE2's potential for cause high inflation in the future. Of course these same skeptics were calling for high inflation after QE1 (back in March of 2009). Clearly, they were wrong the first time (evident by the need for QE2) and I suspect will be wrong the second time.  QE1 consisted of $1.25 trillion in debt purchases (government bonds and mortgage backed securities) meanwhile the Fed announced QE2 will result in $600 billion (less than half of QE1).

The concern is not high inflation, the Federal Reserve will not let inflation go above 3-4%. The concern is the cost of preventing high inflation. The Federal Reserve has the ability to reign in the money supply (remember banks use the excess cash from the Fed to make loans, as loans increase the money supply increases) and prevent prices for drastically increasing. They can raise interest rate on reserve holdings. Banks are currently earning 0.25% on their reserves, it would be easy for the Fed to offer a higher right and entice banks to keep reserves with the Fed. Second the Fed can buy back the cash through open market sales. Finally, they could raise the reserve requirement. All three choices would be costly, not only will the Fed take a loss on their open market purchases they would have to pay out a large sum in interest payments. This is the least of my concern. So what if they take a $10-50 billion loss (last year they made more than that on the purchases). The bigger concern would be the effect on a struggling economy. A sudden increase in interest rates (from the debt sell off) could send us back into another recession.

The Fed's actions have probably prevented a double dip recession, made borrowing extremely cheap, and saved taxpayers $100+ billion in future interest payments on the debt. A 1-2% reduction in bond yields means cheap financing for the government when they have issued will over $5 trillion in government bonds these last few years. The a sudden reversal in policy will ultimately cause the double dip recession. I don't necessarily see the latter likely to occur. So in my take the benefit outweighs the cost. 

1 comment:

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