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What's in the Fed's Toolbox? How the Government is Using Quantitative Easing to Fight the Recession


Click for PDF[Reprinted from Perspectives Spring 2011]

Fixing a flat tire usually requires a jack, a wrench, and some elbow grease. But if the lug nuts are rusted, you might need more tools, or even a mechanic, to help you get back on the road.

A stubborn recession has posed the same situation for economic policymakers. The usual tools haven't been enough to heal the ailing economy, so the Federal Reserve has had to reach a little deeper into its toolbox to find a fix.

Quantitative easing is a specialized "jack" that the Fed hopes will help lift the U.S. economy. Essentially, an effort to pump vast new sums of money into the economy, quantitative easing is not a step the Fed took lightly, nor without consideration of the many potential risks as well as the benefits. By purchasing about $2 trillion in long-term Treasuries and mortgaged-backed securities from 2009 through early 2011, the goal was to get money into the hands of banks for them to lend and to drive down long-term interest rates so that businesses and consumers would want to borrow and spend. The purchases were done in two rounds, known as QE1 and QE2.

The cash infusion did drive down interest rates, but it also spurred ripple effects that penetrated every corner of the U.S. economy and much of the rest of the world. For instance, quantitative easing caused the dollar to lose value. "Declines in the dollar are a double-edged sword," says Anne Villamil, professor of economics. "A weaker dollar boosts U.S. exports and lowers the trade deficit, but it also raises the cost of oil and other imports, adding to inflation." Meanwhile, other nations complain that the weaker dollar makes their exports to the United States more expensive and costs them business and jobs.

Hammering Out a Strategy

Congress has given the Federal Reserve the mandate to promote a high level of employment and low, stable inflation. Lowering short-term interest rates is one tool the Fed uses to meet those goals. But with short-term interest rates already about as low as they could go, and employment still high, the Fed determined that additional easing of monetary policy was needed to support the economy.

"At that point, you can't push those short-term rates any lower," observes Charles Kahn, professor of finance and department head. "So what do you do? You go to longer-term instruments, which are still paying something." He believes quantitative easing is "no more damaging than the old method of buying short-term instruments."

But because it's a less common practice, it has some economists worried. Federal Reserve Chairman Ben Bernanke addressed those concerns after the announcement of QE2 in an op-ed piece in The Wall Street Journal: "Purchases of longer-term securities are a less familiar monetary policy tool than cutting short-term interest rates. That is one reason [we've] been cautious, balancing the costs and benefits before acting. We will review the purchase program regularly to ensure it is working as intended and to assess whether adjustments are needed as economic conditions change."

Trying to quantify how much quantitative easing helps or hurts the U.S. economy may not be possible. "Oil prices have been driven up by (both) turmoil in the Middle East and QE2," says Villamil. And she notes that quantitative easing by the Fed was accompanied by other measures to boost the economy, including tax cuts and increased government spending.

What quantitative easing did do, says Kahn, is show Americans that the Fed hadn't run out of mechanisms to fight the downturn. "If the Fed had had nothing left in its toolbox, consumer and business confidence would have suffered. Confidence is important."

But the potential for long-term harm has some U.S. and foreign economists concerned. They argue that low interest rates may help spur the creation of asset bubbles or that inflation might soar if the Fed doesn't withdraw the huge sums of money it has pumped into the economy in time.

In fact, just the fear of high inflation could cause problems. "There is a risk that some investors might say there's no way to reverse this in time to avoid high inflation, so I'm selling my Treasuries right away," says William Emmons, assistant vice president and economist at the Federal Reserve Bank of St. Louis and an ILLINOIS business administration graduate. "So it's a fragile balance. With these new tools, there is higher level of risk that people might lose faith. It could happen that something of a panic could set in and foreign investors could start dumping Treasuries because they don't believe the U.S. could keep inflation under control. If that happens, then the policy fails."

And Emmons cautions that no one should expect a quick fix from quantitative easing. "Because the Fed's anti-recession measures were so extraordinary, getting back to normal monetary policy could take a long time, maybe three, four, or five years just to normalize things. And there's the risk of something going really wrong in the meantime. It's as if you hiked up a really high mountain—it's a long way home."

George Pennacchi

Time to Retool

The number of economic sectors impacted by quantitative easing is large. Debtors benefit from lower interest rates—and the United States is mired in debt, both nationally and individually. At the same time, savers suffer as returns on their fixed-income investments wither. "When you lower the cost of credit to people getting mortgages, you're reducing the return that long-term investors get, which hurts certain groups, like retirees," says Finance Professor George Pennacchi. "In turn, some people may be taking on too much credit risk (by investing in junk bonds) because that's the only way they are able to get higher rates of return."

And while the weaker dollar helps U.S. exporters, it "could have a depressing effect on at least some U.S. industries that depend on imported commodities, such as oil," Pennacchi says. Quantitative easing may also be triggering a series of secondary impacts that haven't received a lot of attention. "When oil prices go up, more farmers shift their production from food to ethanol," says Pennacchi. "The result is higher food prices."
Pennacchi adds, "It's unlikely that quantitative easing will make everyone better off. There will be winners and losers. And it may not be such a good deal if the Fed can't reduce quantitative easing at some future point to avoid higher inflation."

Bernanke, in his op-ed piece, says concerns about significant increases in inflation are overstated. "Our earlier use of this policy approach had little effect on the amount of currency in circulation or on other broad measures of the money supply, such as bank deposits. Nor did it result in higher inflation. We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time."

In recent testimony before the Senate Banking Committee, Bernanke also maintained that the rise in both oil and other commodity prices would not result in widespread inflation. In fact, he rejected the notion that quantitative easing is primarily to blame for rising commodity prices. The culprit, he said, lies with "rising global demand for raw materials and constraints on global supply."

It's Debatable

Meanwhile, quantitative easing has caused some foreign governments—China, Brazil, and Germany among them—to complain the policy wouldn't work or was downright harmful to their interests. The head of Brazil's central bank said quantitative easing would distort world markets and make it more difficult to halt the rise of Brazil's currency. German Finance Minister Wolfgang Schäuble said, "The U.S. has already pumped endless amounts of money into its economy. The results have been hopeless. And now, to say let's pump more (money) into the market is not going to solve their problem. With all due respect, U.S. policy is clueless."

In the period leading up to the crash of 2008, the Fed repeatedly fine-tuned its actions to keep the economy out of recession. As a result, some people thought the economy had been freed from the downside of the business cycle. But this proved an illusion—the downside had merely been postponed. During the good years, bubbles had formed in housing and stock prices, and both eventually burst.

Today, some people think the economy would have been better off if the Fed had allowed it to take some knocks during the extended period that preceded the crash, says Emmons, the St. Louis Fed economist. Still others, including some members of Congress, want the Fed abolished.

Bernanke defends the Fed's actions, saying: "The Federal Reserve cannot solve all the economy's problems on its own. That will take time and the combined efforts of many parties, including the central bank, Congress, the administration, regulators, and the private sector. But the Federal Reserve has a particular obligation to help promote increased employment and sustain price stability." He says the steps taken to ease monetary policy help fulfill that obligation.

In the meantime, economists continue to hash over the pros and cons of quantitative easing. "This is something economists will debate for years to come," says Emmons. "And it's something they may never agree on."
– Doug McInnis



The Q&A on QE2

Q What's the Upside of QE2?

?A • Banks have more money to lend.
• The stock market rises.
• Interest rates fall.
• The overall economy gets a boost.
• Federal Reserve shows it still has tools to fight recession.
• Consumer confidence gets a boost.
• Consumers and business pay less to borrow.
• Home refinancing at lower interest rates gives consumers more cash to spend.
• Exports rise, easing the trade deficit.
• Export growth shores up manufacturing.
• Interest on the national debt falls.

Q What's the Downside of QE2?

A • Oil prices rise.
• Consumers have less to spend as gas prices rise.
• Imported raw materials prices rise.
• The overall cost of imports rises, pinchingconsumers and worsening the trade deficit.
• Food prices rise as some U.S. farmers switch from food to ethanol crops.
• Retirees and other fixed income investors suffer from low interest rates.
• Investors shift to riskier investments to higher yields.

Q What are Additional Risks of QE2?

A • Inflation could rise sharply.
• Investors could dump Treasuries.
• Asset bubbles could form and eventually burst.

UIUC College of Business