Notes on Quantitative Easing 2

1.    Now that Treasury deposits at the Fed have fallen closer to normal levels it is easier to see the effect of Quantitative Easing 2. As can be seen from charts 1&2, practically all the funds injected by the Fed through its purchases of treasury securities ended up in the banks’ excess reserves, i.e. reserves not needed to make loans. There is no surprise there. Excess bank reserves before the operation started were about a $ trillion so the availability of reserves did not pose an effective limit on growth of bank loans.

Chart 1: Quantitative Easing 2

Chart 2: Quantitative Easing 2

2.    One unstated objective of Quantitative Easing 2 was achieved in February. The real trade weighted value of the $US declined to a new low (chart 3). No surprise there either. There were strenuous objections to this operation from around the globe and particularly from countries exporting to the US and those holding large amounts of dollars as foreign reserves. China in particular apparently stopped accumulating dollars some time ago. There may be harsh implications for this debasement of the dollar – – including loss of confidence in it as a reserve currency – – but for now, it helps in improving the US balance of trade and reducing the real value of US debt.

Chart 3: Quantitative Easing 2

3.    Recently the Fed announced a policy target of raising core inflation from about 1% closer to its presumed target of 2%. I proposed a similar policy a couple of years ago in order to ease the down pressure in the housing market. Now, however, maybe a bad time for such a policy. With headline inflation already running high and assuming that by time this policy starts showing results China will be accelerating again – – it has already started easing monetary policy – – and Japan will be pouring money for reconstruction, there is a substantial risk of a further sharp rise in inflation expectations.
In testimony in Congress, Bernanke said he is 100% confident that he could stop the rise of inflation when this is deemed desirable. This would be a reasonable assessment under normal circumstances. All that would be needed is to raise short-term rates high enough. That would be accomplished by the Fed absorbing enough reserves – – via the sale of treasury securities – – to set the market price of reserves (the Federal Funds rate) at the desired level.
In the present situation, however, this would be impossible. The Fed would probably have to sell over a trillion dollars worth of intermediate and long-term treasuries (or MBSs it bought in the Quantitative Easing 1) to mop up excess reserves, before the federal funds rate started to move up. Doing so at a time when the treasury is selling large quantities of securities to finance the budget deficit would crack the bond market. Alternatively, the Fed could raise reserve requirements but here too size would be a problem. Finally the Fed may pay interest on reserves held at the Fed at the rate it wants to set as a floor to the Federal funds rate. This, of course, would be a cost to the taxpayer. Also, it would not reduce the amount of excess reserves and would not set an effective limit on the growth of bank loans and of the money supply. Thus, the effectiveness of such a rate increase in curbing inflation is doubtful.
All in all, there is no easy exit strategy from quantitative easing and the problem is still growing.

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