Now that the Federal Reserve has embarked on a new round of quantitative easing (QE2), what can we expect? The Fed plans to buy $600 billion of longer-term Treasury securities or $75 billion per month by the end of the second quarter ($110 billion monthly including reinvestment of maturing mortgage backed securities) with an average maturity of five to six years.
But all this is subject to change. The policymaking Federal Open Market Committee (FOMC) said Nov. 3 it will “regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.”
St. Louis Fed President James Bullard told me the FOMC has the flexibility to adjust how much bond buying it does, in either direction.
“Hopefully, the economy will do well enough that we don’t have to do any more,” one policymaker confided.
But Chicago Fed President Charles Evans, one of this year’s FOMC voters, suggests more may be needed. Fed Vice Chairman Janet Yellen sees inflation “lingering around current levels for a long time” and projects unemployment remaining near 8% at the end of 2012.
For now QE2 is limited to Treasuries, but New York Fed President William Dudley has suggested the Fed could resume mortgage backed securities (MBS) purchases — something others would balk at. Although buying is focused on the five- to six-year maturity range, the Fed could decide to move further out the curve. The Fed will probably carry through with the full $600 billion, unless there is an upside surprise. The more likely dilemma will be whether to go beyond QE2.
Going for a QE3 would involve the same weighing of costs and benefits the FOMC went through last Fall. It judged the benefits of creating more reserves to cut long-term interest rates and, incidentally, affect the dollar exchange rate, which outweighed the risk of accelerating inflation, dollar depreciation and asset bubbles.
There would be opposition to more QE, but Chairman Ben Bernanke wouldn’t have much trouble rallying support if unemployment were to remain high and/or inflation undesirably low as the end of QE2 approaches.
It won’t be as easy for the FOMC to expand QE if joblessness stays high, but inflation and inflation expectations move up. If inflation returns to the Fed’s implicit target range of 1.6-2.0% or even exceeds it, some FOMC members may feel no need to go beyond the scheduled $600 billion. If inflation really picks up, the FOMC even could curtail QE2.
If GDP growth unexpectedly accelerates, that could limit asset purchases. If it falls short, the FOMC could decide more is needed. Unemployment may be the biggest determinant. Bernanke stresses the “incredible importance” of reducing it.
Another factor will be the extent to which bank lending picks up and converts vast excess reserves into faster money supply growth. The worst case scenario would be if inflation and inflation expectations flare, but unemployment stays high. The Fed might be willing to tolerate above-target inflation for a while, but not indefinitely, especially if it gets built into bond yields.
Eventually, the Fed must exit its ultra-easy policy. By resuming QE it has made that task more difficult. Officials have assured us that they have the “tools” to execute an effective “exit strategy.” They could:
- drain reserves through reverse repurchase agreements and could roll over those reverse repos indefinitely.
- convert reserves into term deposits at the Fed, which could not be used as clearing balances or to meet reserve requirements.
- hike interest on excess reserves (IOER) to encourage banks to hold them rather than boost lending. That would entail commensurate rises in the Federal Funds Rate. By raising the IOER the Fed can theoretically exit from a zero funds rate without first shrinking its balance sheet.
- let maturing securities run off and not replace them.
- actively shrink the balance sheet through asset sales.
As with conventional rate cuts, QE2’s impact will be subject to six- to nine-month lags. And there will be other forces impinging on the economy, making it hard for the Fed to know whether it has done enough and when it should start tightening.
Given the forecasting challenges, the Fed could find itself on a slippery slope. What if the end of the $600 billion nears and GDP, jobs and inflation are still at odds with dual mandate goals? Will the FOMC up the ante and announce QE3? Then QE4, making the balance sheet and the exit task ever larger? The FOMC always has faced such judgment calls, but QE is different.
Fed Governor Kevin Warsh warns, “As the Fed’s balance sheet expands, it becomes more of a price maker than a price taker in the Treasury market. And if market participants come to doubt these prices — or their reliance on these prices proves fleeting — risk premiums across asset classes and geographies could move unexpectedly...”
Even when it was running policy conventionally, the Fed didn’t have a great record for shifting to a tighter policy in a timely way. The tendency has been to overstay accommodation.
The exit is far off. Because it can’t cut the funds rate further, it can’t have a traditional “easing bias.” But it does have a “quantitative easing bias” that’s likely to be in place quite awhile.
If the Fed gets what it wants, more inflation, it may need to raise rates quickly, even while maintaining a bloated balance sheet. The Fed just would have to hope it could use the IOER to set a floor under the funds rate and move rates up.
The ultimate questions are ones of will and judgment.
Steve Beckner is senior correspondent for Market News International, a regular on National Public Radio and author of “Back From The Brink: The Greenspan Years” (Wiley).