On November 3rd the Federal Reserve announced that it intends to purchase $600 billion of longer-term U.S. Treasury securities by the end of the second quarter of 2011. This equates to $75 billion in purchases per month. This planned policy is referred to as quantitative easing (QE).To achieve it’s goal the Fed will literally create this money out of thin air to purchase the securities.
It is the Fed’s intention to increase the supply of money in the economy via these purchases. In buying the Treasuries from the banking system, banking institutions will be left with excess cash. Leaving this cash on the balance sheet will earn the bank very little interest at the very low rates we see today, so in order to make a profit, it is the Fed’s hope that banks will lend this excess cash. Loans are used for investment, and it is the expectation of the Fed that these loans will be used by businesses to expand. The expansion of businesses would then help reduce the high employment rate we currently see. By purchasing debt the Fed is also influencing the interest rate of Treasuries and, as mortgage rates generally move in step with Treasury interest rates, this could result in the refinancing of mortgages. This would then leave more money in the pockets of individuals. Low mortgage rates also might encourage more people to purchase a home.
This is not the first time that the Fed has used quantitative easing. Over the course of 2009 the Federal Reserve purchased $1.25 trillion in mortgage backed securities, $300 billion in U.S. Treasuries and $200 billion in federal agency debt. This had the effect of lowering interest rates and, it can be argued, helped the economy to expand. The latest round of planned quantitative easing, however, indicates that the economy is not growing at a quick enough pace for the Fed and that deflation or disinflation remains a threat. Inflation has been range bound at an annualized rate of between 0% and 1.5% every month this year, well below the 2% target the Fed sets. In addition unemployment has remained stubbornly high.
There are potential downsides to this planned purchase of Treasury securities by the Fed.First, by purchasing Treasuries the Fed is going to be increasing the demand for Treasuries, thereby raising the price. This could cause an issue in the future when interest rates begin to rise, which will cause Treasuries to fall in price. Second, this action could cause U.S. dollar to depreciate relative to other currencies around the world. While this would help U.S. firms that export goods and services, it would make foreign goods more expensive for the American consumer and raw inputs from abroad more expensive for U.S. firms. Third, low interest rates in the U.S., relative to other countries, could encourage what is known as the carry trade. The carry trade occurs when an investor borrows at a low rate in a country such as the U.S. and lends the proceeds of the loan in a country with higher interest rates, such as Brazil. This could stoke inflationary pressures in the second country as a large amount of capital flows into the country. Finally, while part of the reason the Fed has enacted this policy is to meet it’s 2% inflation target, it is possible that the Fed will purchase too many securities resulting in inflation higher than the 2% it targets.
The Federal Reserve announced QE2 via a written statement, and as is typical of any Fed announcement, it is necessary to decode the message and read between he lines. To this end, the NPR, Planet Money Blog has created a useful translation of the text, putting it into decipherable terms.