The Federal Reserve significantly increased bank reserves and the monetary base after Lehman Brothers announced on September 15, 2008, that it had filed for chapter 11 bankruptcy protection. The Fed took additional steps toward quantitative easing (QE) on March 18, 2009, when it announced that it would purchase up to $1.725 trillion in mortgage-backed securities and government and agency debt.

Recent speculation that the Federal Open Market Committee (FOMC) may purchase an additional large quantity of government debt to stimulate economic growth, increase employment, and prevent deflation has prompted considerable debate over the effectiveness of additional quantitative easing (QE2). This synopsis analyzes some of the central issues in this debate.

One key issue is whether additional large-scale securities purchases by the Fed would cause interest rates to decline significantly. Recently Gagnon et al.1 used several methods to investigate the effect of the FOMC’s announced securities purchases ($1.725 trillion) on the 10-year Treasury yield, which they estimate to be in the range of 38 to 82 basis points.

Some might conjecture that an FOMC commitment to purchase, say, an additional $1 trillion in securities could reduce the 10-year yield by a comparable amount (22 to 48 basis points). These estimates may be too large and need to be confirmed by further research. Moreover, some commentators (e.g., Narayana Kocherlakota, president of the Minneapolis Fed2) have suggested QE2’s effect on Treasury yields may be “muted” because financial markets are functioning much better than they were in the spring of 2009.

There is another reason that the effect on interest rates could be small. Banks are currently holding about $1 trillion in excess reserves rather than making loans and increasing the supply of credit to the non-banking segment of the credit market. It is possible—perhaps even likely—that almost all of any increase in the supply of credit associated with QE2 simply would be held by banks as excess reserves.

If so, the effect of QE2 on interest rates could be small and limited to an announcement effect—the effect associated with the FOMC’s announcement—independent of the effect of the FOMC’s actions on the credit supply.

Even if QE2 did affect interest rates, many believe that the effect on output or employment would be small. For example, Charles Plosser, president of the Philadelphia Fed and a nonvoting member of the FOMC, recently suggested that “[I]t is difficult…to see how additional asset purchases by the Fed, even if they move interest rates on long-term bonds down by 10 or 20 basis points, will have much impact on the near-term outlook for employment.” One reason is that even in normal times, investment spending is not particularly responsive to changes in interest rates: Investment spending depends more on the economic outlook.

Consequently, some analysts believe that reducing interest rates modestly from their already historically low levels is unlikely to stimulate aggregate demand: Little effect on aggregate demand implies a corresponding small effect on output and, hence, employment.

Read Full: Would QE2 Have a Significant Effect on Economic Growth, Employment, or Inflation?

PDF format, 66KB.

Daniel L. Thornton, Vice President and Economic Adviser

Economic SYNOPSES
short essays and reports on the economic issues of the day
Federal Reserve Bank of St. Louis

Finally, it should be noted that QE2 could have adverse effects. For example, Plosser has expressed concern that if the FOMC undertakes QE2 and the actions are ineffective, it could damage the “Fed’s credibility and possibly erode the effectiveness of our future actions to ensure price stability.” He suggests that QE2 might also raise concerns that “the Fed is seeking to monetize the deficit [which] might make it more difficult to return to normal policy” in the future.

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