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Quantitative Easing: Unknown Consequences

Quantitative Easing: Unknown Consequences
Guest Contributor
09/21/10 – 01:35 PM EDT
Excerpted with permission from the publisher, John Wiley & Sons, from The Little Book of Economics by Greg Ip. Copyright © 2010 by Greg Ip.
By Greg Ip

In December 2008, the Fed hit an ominous milestone. As the U.S. economy spiraled down in the wake of Lehman Brothers’ collapse, it concluded the damage to the economy would be so great that it had to cut the Federal Funds rate all the way to zero, or more precisely, to between zero and 0.25 percent. Was there anything left it could do?

Another tactic would be to buy foreign currencies in exchange for newly printed dollars, depressing the dollar’s value and helping exports. But by hurting imports, this would come at other countries’ expense. So a central bank that has cut short-term rates to zero is, practically speaking, out of bullets.

A soldier out of bullets still has a bayonet. The Fed did the equivalent of reaching for its bayonet. Between 2008 and 2010, it bought $ 1.75 trillion worth of Treasury bonds and mortgage-backed securities by printing money. Its balance sheet ballooned from under $1 trillion to over $2 trillion and banks’ reserves skyrocketed from almost nothing to more than $ 1 trillion.

When a central bank shifts its focus to expanding its balance sheet through bond purchases rather than targeting short-term interest rates, it is called quantitative easing. This stimulates the economy in two ways.

1. When bond prices rise, their yields decline. So the Fed’s buying nudged down long-term interest rates, boosting interest-sensitive spending on items like houses.

2. Since banks don’t earn much on reserves, they may lend them out to make higher-returning loans to businesses and households. That’s the rationale used by the Bank of Japan starting in 2001 and the Bank of England in 2009 when they tried the same thing.

In theory, quantitative easing endows the Fed with awesome power. It could buy up every U.S. bond in existence. Yet, in practice, this is the Star Trek of central banking, taking the Fed into strange new worlds with unknown consequences.

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