Posted on February 18th, 2011
Quantitative easing 2 was explicitly intended to boost the economy through three channels: First it was supposed to increase bank reserves and the monetary base (reserves+ currency), inducing the banks to increase lending. However, much of the injected reserves somehow found their way into Treasury deposits at the Fed (which are not bank reserves), so the monetary base today is no higher than it was in Feb. of last year. (Chart 1).
This would have been an interesting subject to discuss if it were not for the fact that excess reserves, i.e. reserves not used for lending, are over a trillion dollars. (Chart 2). Clearly, if the banks hesitate to lend it is not for lack of reserves but due to shortage of capital and the fact that they are shell shocked by events in the past couple of years. As a result, the funds injected by the Fed that did accumulate in bank reserves just added to excess reserves. (Charts 1, 2)
The second avenue for quantitative easing to boost the economy is by reducing intermediate and long term interest rates, and particularly mortgage rates. But while the purchase of bonds by the Fed tends to increase their price and reduce yields it also increases inflation expectations. And against the background of huge budget deficit, commodity prices that are shooting up and high inflation rates in the developing world it is no surprise that the latter has been the dominant result. (Chart 3). As a result mortgage rates increased 80 basis points and the rate on 10 years treasuries – - the regularly auctioned note closest in duration to 30 year mortgages- – increased over one percent. (Charts 4, 5).
A third way of helping the economy by quantitative easing – - and one strongly emphasized by Bernanke- – is by increasing public confidence in the economy, be it consumers, investors, lenders and any other sector. On that, however, see below.
Quantitative easing could also boost the economy by weakening the dollar and raising stock prices. These were not explicitly stated as objectives of the operation because the Fed is not supposed to manipulate these markets but they were mentioned in the FOMC minutes.
As for the dollar, the FOMC worried about “unwanted” depreciation. In fact, the dollar declined by almost 5 percent between Bernanke’s announcement of his quantitative easing plans in Jackson Hole and the FOMC decision to initiate the plan but hasn’t changed since. (chart 6). This, however, is not due to lack of impact of the program but to the inherent weakness of the Euro and the manipulation of the Yuan. The stock market, on the other hand, started a strong rally after Jackson Hole that has continued to date. It is difficult to dissect all the influences on the market but it is clear from observing the market at the time and from the discussion above that at least the first leg of the up move – - to the beginning of the easing – - was motivated mostly by psychology. Investors simply looked at past experience in QE1 and in Japan and were encouraged to buy. (chart 7). Other factors, such as an improvement in the economy, strong economies of the developing world, strong fiscal stimulus, the shift of Obama after the elections from left to center and yes, even the statement by the Fed that it will follow a policy intended to raise inflation, have all joined to push the market higher.
All told, it appears that the stock market rally is boosting the economy more than the other way around, and the economy still needs a strong push by policy. Given that some major structural problems – - mainly in the state and local government budgets and in the housing sector – - have not been seriously addressed, the European problem still unresolved and rising commodity prices, inflation and interest rates in the developing world, the US and world economy are still highly unstable. But the continuing process of increasing productivity in the US can keep corporate profits rising and drive the stock market to new highs, possibly after a more serious correction that is long overdue.