• The Fed appears set to buy $500 billion to $1 trillion in Treasury notes
On Wall Street, they call it QE2, short for a second round of quantitative easing by the Federal Reserve. By all signs, the Fed is ready once again to begin buying large quantities of assets such as Treasury notes. But what will it mean for Main Street? After all, the ultimate measure of the policy’s success will be whether or not it boosts economic growth and creates jobs.
After cutting the interest rate it controls to near zero, the Fed has already completed a first round of quantitative easing, which involves buying assets to effectively lower borrowing costs for businesses and consumers. QE1, in which the Fed bought $1.7 trillion in mortgage-backed securities and other assets from March 2009 to March 2010, is generally credited with ending the financial crisis. But despite past efforts, policymakers still have no assurance that the economy will grow fast enough to bring down unemployment, even amid new concerns that inflation is falling too rapidly. “Prolonged high unemployment would pose a risk to consumer spending and hence to the sustainability of the recovery,” said Fed Chairman Ben Bernanke on October 15, as he discussed the case for further action.
Those actions are expected to be outlined at the Fed’s meeting Nov. 2 and 3, but Round 2 will most likely look different from Round 1. Unlike QE1, economists expect an open-ended, step-by-step policy, with no predetermined amount of purchases and buying focused on Treasury securities of two-year to 10-year maturities. Some economists project a series of purchases running at perhaps $75 billion to $100 billion per month. The ultimate amount and length of the program will be determined by the Fed’s reading of economic conditions, but most analysts think the total effort will end up between $500 billion and $1 trillion, lasting up to one year.
“QE2 will work through several channels,” says Morgan Stanley economist Richard Berner. “It will lower financing costs, boost risky asset prices and household wealth, and continue to weaken the dollar.” The program hasn’t even begun, and already it has started to work, as market expectations work their way into asset prices. Since Bernanke’s August speech, which raised the possibility of more asset purchases, 30-year fixed mortgage rates have fallen to a 60-year low, according to Freddie Mac, before ticking up to 4.21 percent last week. Stock prices are generally up about 10 percent, fully reversing their second quarter drop, and the trade-weighted dollar has fallen more than 5 percent.
In theory, these market moves will help support credit-sensitive spending by consumers and lift household wealth, easing the need to further boost savings. They have already set off a refinancing boomlet for eligible homeowners, which can reduce debt burdens and put money in peoples’ pockets. And they will provide added thrust to U.S. exports. If sustained, the lift to household wealth will add some $44 billion to consumer spending, and the cheaper dollar will boost net exports by about 1 percent of GDP, according to Morgan Stanley calculations.
In practice, however, many analysts are skeptical of what QE2 can do. The impact on interest rates and growth could be small. The Fed’s first effort of more than $1.7 trillion resulted in declines in 10-year Treasury yields estimated between a 0.38 and 0.82 percentage point, according to research at the New York Fed. Given QE2’s smaller expected purchases and the likely baby-step approach, the effect would most likely be much smaller. Estimates of additional economic growth from a program of the expected size are generally only a few tenths of a percentage point, which would have a minimal impact on job growth.
In order to have any impact at all, the money the Fed pays to banks for some of their Treasury securities will have to find its way into additional lending and new credit. “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,” says economic adviser Daniel Thornton at the St. Louis Fed.
Also, if the intent is to spur business expansion and hiring, lower interest rates aren’t much of an inducement, especially since corporate borrowing rates are already very low and large companies are flush will idle cash. Businesses expand primarily based on their assessments of current and future sales. “Business contacts continue to tell me that interest rates are not the pressing issue,” said Kansas City Fed President Thomas Hoenig in a recent speech. Hoenig, who is opposed to QE2, says uncertainties over taxes, health care, and an unsustainable fiscal policy are the real issues holding companies back.
The big question policymakers and economists are grappling with is whether the benefits of QE2 will outweigh the risks. Hoenig is especially concerned that an open-ended policy with only vague terms and goals for the size of the program and the targets for unemployment and inflation will introduce even more uncertainty into the markets. In particular, the long-term effects of such an untested policy in a growing economy are unknown, especially with regard to inflation.
However, the risks of not doing QE2 are also significant. Economic studies show that recoveries after a financial crisis tend to be painfully slow with high unemployment, the perfect breeding ground for deflation akin to Japan’s experience in the 1990s and in the U.S. in the 1930s. Adam Posen, senior fellow at the Peterson Institute for International Economics* and an external member of the Bank of England’s policy committee, believes the challenge for policy right now is not about fine tuning the short-run ups and down of recession and recovery. “The case for doing more is about activism for sustaining a period of recovery from a low point, thereby preventing us from getting stuck in a long-term trap,” he recently told a British business group. Clearly, the stakes are high, but the Fed appears ready to gamble.
The Peterson Institute gets its principal funding from Peter G. Peterson, who also funds The Fiscal Times.