On November 3, 2010, the Federal Reserve (Fed) announced that it would purchase an additional $600 billion of Treasury securities, an action that has popularly been dubbed quantitative easing or "QE2." This announcement followed purchases of $300 billion of Treasury securities, $175 billion of agency debt, and $1.25 trillion of agency mortgage-backed securities (MBS) since March 2009. While there may not be a universally accepted definition of quantitative easing, this report defines quantitative easing as actions to further stimulate the economy through growth in the Fed's balance sheet once the federal funds rate has reached the "zero bound." Congress has given the Fed a statutory mandate to "promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates," and the Fed has made the case that quantitative easing can help it to fulfill its mandate. In its announcement of QE2, the Fed explained its decision by citing "disappointingly slow" progress toward achieving a reduction in unemployment and stable inflation, which has been falling. By contrast, critics argue that unconventional monetary actions such as QE2 could be destabilizing and ultimately result in high inflation. In the case of asset purchases, the funds to finance the purchase are credited to the seller's reserve account at the Fed, or if the seller is not a member of the Federal Reserve system, the funds eventually lead to an increase in a member bank's reserves as the proceeds get deposited into the banking system. In normal times, banks would be expected to lend out those reserves, and this would stimulate overall spending in the economy. Based on the experience to date, QE2 can also be expected to lead to an increase in bank reserves similar in size to the amount of assets being purchased. Another option would be to give banks incentives not to lend out reserves by raising the interest rate that the Fed pays on reserves, thereby keeping the larger monetary base from increasing the broader money supply. It is unlikely that reverse repos operations could be large enough to remove most of the new liquidity, however. If inflationary expectations remain low, it would be expected to make an exit strategy, and monetary policy generally, more effective. That profit is largely remitted to the Treasury, where it is added to general revenues, thereby reducing the budget deficit. As the Fed has increased the interest-earning assets on its balance sheet, its profits have increased. Net income increased to $52.4 billion and remittances to the Treasury rose to $47.4 billion in 2009. The Treasury Supplemental Financing Program also has implications for the federal budget deficit. Monetizing the deficit occurs when the budget deficit is financed by money creation rather than by selling bonds to private investors. Section 14 of the Federal Reserve Act legally forbids the Fed from buying newly issued securities directly from the Treasury, and all Treasury securities purchased by the Fed to date have been purchased on the secondary market, from private investors. Nonetheless, the effect of the Fed's purchase of Treasury securities on the federal budget is similar to monetization whether the Fed buys the securities on the secondary market or directly from Treasury. If the Fed chose instead to buy assets with a goal of increasing its profits and remittances, it would be unlikely to meet its statutory mandate. Instead, bank lending fell 0.3% over the past year, and the doubling in the portion of the money supply controlled by the Fed (roughly equivalent to the growth in the Fed's balance sheet), did not translate into large increases in overall measures of the money supply. Some critics have complained that QE2 will lead to a weaker dollar. Inflation is still close to zero, and has been falling. The Fed seems somewhat reluctant to pursue this strategy as long as the housing market remains fragile because it would likely involve the sale of its mortgage-related assets.
On November 3, 2010, the Federal Reserve (Fed) announced that it would purchase an additional $600 billion of Treasury securities, an action that has popularly been dubbed quantitative easing or "QE2." This announcement followed purchases since March 2009 of $300 billion of Treasury securities, $175 billion of agency debt, and $1.25 trillion of agency mortgage-backed securities (MBS). (The agency debt and MBS were primarily issued by Fannie Mae and Freddie Mac.) This report defines quantitative easing as actions to further stimulate the economy through growth in the Fed's balance sheet once the federal funds rate has reached the "zero bound."
In its announcement of QE2, the Fed justified its decision by citing the "disappointingly slow" progress to date toward achieving its statutory mandate of maximum employment and stable prices. By contrast, critics believe that unconventional monetary actions such as QE2 could be destabilizing and ultimately result in high inflation.
There are several ways that quantitative easing can affect the economy. It would be expected to reduce yields on the securities being purchased, and this could have a cascading downward effect on private yields that could stimulate investment spending. Like any monetary stimulus, it could put downward pressure on the dollar, which would stimulate exports and U.S. production of import-competing goods. The initial quantitative easing following the 2008 crisis helped restore liquidity to the financial system, although this channel is arguably not as important now that liquidity has generally been restored. Finally, the direct effect of quantitative easing to date has been to increase bank reserves by over $1 trillion. If banks choose to lend these reserves, it would stimulate economic activity and increase the money supply. But lending has fallen in the past year, and there have been only relatively modest increases in the overall money supply.
Nevertheless, the increase in bank reserves could eventually result in large increases in the overall money supply, which could arguably make it difficult for the Fed to meet its statutory mandate to keep inflation low and stable. The Fed has explored different methods of unwinding quantitative easing if inflationary pressures rose, which have been referred to as the "exit strategy." One method would be to directly reverse quantitative easing by selling some or all of the additional securities that the Fed has purchased, which would automatically withdraw reserves from the banking system. A drawback to this approach is that large sales of securities would probably involve selling its mortgage-related securities, and this could be destabilizing to a housing market that is still sluggish. Another method would be to raise the interest rate that the Fed has been paying to banks on reserves since 2008 to a level high enough that it would give banks an incentive to keep the funds parked at the Fed rather than lending them out. This approach is largely untested, however, and the associated expenditure could become large relative to the Fed's overall profits at historically normal levels of interest rates.
Since the Fed remits most of its profits to the Treasury, where these are added to general revenues, both quantitative easing and its unwinding have implications for the federal budget deficit. Since quantitative easing increases the amount of income-earning securities held by the Fed, it would be expected to increase its profits and reduce the federal budget deficit. Indeed, profits increased from $38.8 billion in 2008 to $52.4 billion in 2009. Similarly, unwinding QE would be expected to reduce the Fed's profits. Some critics have argued that the Fed is monetizing the budget deficit through QE2. The Fed is legally prohibited from purchasing federal debt directly from the Treasury, but Fed purchases of Treasury securities on the open market have a similar effect on the budget deficit as if those purchases were made directly.