Quantitative Easing (QE3): An Analysis

By Alabama Policy Institute

Quantitative easing (QE) is a monetary policy tool employed by central banks in many countries; the Federal Reserve (the Fed) is the central bank of the United States. QE is designed to stimulate the economy by injecting a predetermined amount of cash into the monetary market. Through QE, the Fed electronically creates new money and uses it to purchase financial assets from banks and deposits this new money on the banks’ balance sheets.1 Although many refer to this as “printing money,” new, physical money is rarely created as a result of the Fed’s actions. Because this new virtual money is created by the Federal Reserve, the only approved source of currency in the country, it is accepted as legal tender. However, the responsibility of printing physical money is still in the hands of the Treasury Department.2

By significantly increasing the volume of available dollars, the Fed anticipates that banks will increase the number of loans they make and consequently move more money into the market, prompting economic growth.

The Fed has already implemented QE twice since the beginning of the financial collapse in 2007. QE1 lasted from November 2008 to the first quarter of 2010. During this period, the Fed initiated purchases of $1.25 trillion of mortgage-backed securities, and $175 billion of government agency debt.3 In November of 2010, the Fed announced QE2, during which the Fed began the purchase of $600 billion of longer-term Treasury securities in addition to continuing to reinvest payments on securities purchased during QE1.4

The Fed announced on September 13th that it was dissatisfied with the economy’s rate of recovery, specifically the slow rate at which unemployment levels are returning to a more normal range5, and would attempt to remedy the stagnated growth by beginning QE3. In this round of quantitative easing, the Fed will purchase $40 billion a month in Mortgage Backed Securities, as well as continue the program dubbed “Operation Twist,” with the purchase of longer-termed securities.6 QE3 is open-ended. In a press release, the Fed stated that it would continue to purchase securities at this rate until it saw the desired results.7

Policy Considerations

Under the right circumstances, increasing the supply of money can spur economic growth, but it can also introduce the risk of devaluation of the currency8. QE can mean higher commodity prices and higher inflation. Esther George, president of the Kansas City Federal Reserve Bank, has raised concerns that QE3 has “the potential for igniting inflation.”9 Inflation essentially makes each dollar worth less, and in an economy where wage rates are stagnant, the consequences could be dire10.

Another concern is that the intended goal of QE to increase the amount of money available to lenders and, ultimately, the marketplace has not been entirely successful. The reason may lie, at least partially, in another program implemented by the Fed. In October 2008, in an effort to deter the fears of depositors, the Fed began paying interest to banks for the funds they keep in reserves.11 While all banks within the Federal Reserve System are required to maintain a certain level of reserves available for depositors who may want to withdraw their cash, they are deterred from keeping excess reserves by other market forces. Absent the Fed paying them interest on all reserves, including excess reserves, banks would be more inclined to loan money in order to increase income from interest payments. The rate of interest paid on bank reserves is currently 0.25 percent.12 That may not sound like much, but the daily federal funds rate has been held between 0 and 0.25 percent for the last several years13. When accounting for inflation, real interest rates are hovering near zero14, so a risk-free 0.25 percent return is actually a bargain for banks. As of August 2012, banks that deposit with the Fed are holding nearly $1.5 trillion in excess reserves, up from close to zero historically.15

In short, the Fed is incentivizing banks to keep the excess money they receive from QE programs in their reserves in order to collect the interest paid by the Fed. While mortgage rates did decline after QEs 1 and 2, even former Federal Reserve Chairman Alan Greenspan calculated that, as of July 2012, there was “very little impact on the economy”, adding that he was “very surprised at the data.”16 Former Chairman Greenspan also commented that the effect of the untold trillions of government and Fed spending actually may have had a negative impact on the health of the economy. He posits that the rash of deficit spending and manipulation of the interest rate is crowding out private investments.17

Conclusion

If the former Chairman of the Federal Reserve has doubts that quantitative easing efforts have brought about the promised economic stimulus, why is the Fed proceeding with the same old bag of economic tricks? As API has discussed before, there are multiple places where the Fed’s missions and actions are in direct conflict with one another; attempting to push “created” money into the marketplace while simultaneously incentivizing banks not to lend money is yet another conflict that must be seriously reevaluated.

1 Quantitative Easing, FINANCIAL TIMES LEXICON, http://lexicon.ft.com/Term?term=quantitative-easing
2 Kimberly Amadeo, Federal Reserve is Printing Money, http://useconomy.about.com/od/glossary/g/Federal-Reserve-Printing-Money.htm.
3 Polyana da Costa, QE1: financial crisis timeline, http://www.bankrate.com/finance/federal-reserve/qe1-financial-crisistimeline.aspx.
4 Polyana da Costa, QE2: financial crisis timeline, http://www.bankrate.com/finance/federal-reserve/qe2-financial-crisistimeline.aspx.
5 Press Release, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM, (September 13, 2012) http://www.federalreserve.gov/newsevents/press/monetary/20120913a.htm.
6 Id.
7 Id.
8 Jeffry Rubin, Quantitative Easing is Just Devaluation, http://www.huffingtonpost.com/jeffrey-rubin/quantitative-easing-isju_b_777970.html.
9 Don Mecoy, Federal Reserve Official Disagrees with Monetary Policy Decisions, (September 19, 2012), http://newsok.com/federal-reserve-officialdisagrees-with-monetary-policy-decisions/article/3710981.
10 Wage Growth in the U.S. Will Feel Effects of Great Recession for Years to Come, (April 26, 2012), http://www.conferenceboard.org/press/pressdetail.cfm?pressid=4466.
11 Press Release, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM, (October 6th, 2008) http://www.federalreserve.gov/newsevents/press/monetary/20081006a.htm.
12 Interest on Balances Maintained to Satisfy Reserve Balance Requirements and Excess Balances, THE FEDERAL RESERVE SYSTEM, http://www.frbservices.org/files/reserves/pdf/calculating_required_reserve_balances_and_excess_balances.pdf
13 Federal Funds Data Historical Search, FEDERAL RESERVE BANK OF NEW YORK, (July 1, 2010-July 31,2012), http://www.newyorkfed.org/markets/omo/dmm/historical/fedfunds/ff.cfm.
14 Rodney Sullivan, Negative Real Interest Rates: The Conundrum for Investment and Spending Policies, http://blogs.cfainstitute.org/investor/2012/07/03/negativereal-
interest-rates-the-conundrum-for-investment-and-spending-policies/.
15 Excess Reserves of Depository Institutions, FEDERAL RESERVE BANK OF ST. LOUIS, http://research.stlouisfed.org/fred2/series/EXCRESNS.
16 Bruno J. Navarro, Alan Greenspan Sees ‘Two Separate Economies’, (July 12,2012), http://finance.yahoo.com/news/alan-greenspan-sees-two-separate-161122638.html.
17 Id.

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