The Return of Quantitative Easing

The Federal Reserve Open Market Committee has announced a resumption of quantitative easing, a monetary policy designed to keep interest rates low to stimulate a more robust economic recovery.

As justification for the policy, the Fed summarized the current sluggish economic recovery as follows:

Information received since the Federal Open Market Committee met in September confirms that the pace of recovery in output and employment continues to be slow. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls. Housing starts continue to be depressed. Longer-term inflation expectations have remained stable, but measures of underlying inflation have trended lower in recent quarters.

The Fed announced two elements as part of its policy.  First, the Federal Reserve will continue to reinvest payments of principal for its stock of existing securities holdings.  The New York Fed estimated a total of $250 to $300 billion of such transactions will occur, with the payments reinvested in Treasury securities. 

Second, the Fed will purchase $600 billion of Treasury securities through the end of the second quarter of 2011, at roughly $75 billion per month pace ($110 billion per month when including the principal payment reinvestment).

The Federal Reserve Bank of New York estimated that at least 91% of the purchased securities will have a maturity of 10 years or less, with an average duration of between 5 and 6 years.

The Federal Reserve has previously purchased approximately $1.7 trillion in government and mortgage-backed securities.

The stock market appears to have had little immediate reaction to the announcement, which had been the subject of speculation for weeks, suggesting that the policy’s expected effects are already priced into stocks.  Nonetheless, the Fed purchases should have the effect of keeping long-term interest rates at or even below current levels, which will also keep mortgage interest rates at historically low levels. 

Internationally, the purchases could have the effect of weakening the dollar.  Investors may seek higher investment returns outside the United States, thus increasing the demand for non-dollar assets, causing an appreciation of foreign currencies.  This would have the impact of increasing the cost of imports but raising the level of U.S. exports. And in fact, in the weeks preceding the announcement the dollar index is down more than 8%.

Some analysts have expressed skepticism that the resumption of quantitative easing will improve the prospects for a robust U.S  recovery.  Some have even suggested the policy is harmful in that it will ultimately lead to inflation down the road.  However, these concerns are likely exaggerated because of the extended time period that the Fed has to unwind its balance sheet, as well as the absence of inflationary pressures in the economy today.



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