Quantitative Easing

The Fed announced yesterday that they would begin buying up close to $1.2 trillion in long-term debt - mortgages, 10-year Treasury bonds, etc.  So 1) why did they do this, and 2) why might you care?

1) Why do this?  The Fed has the long-run objectives of keeping inflation low and maintaining the economy at close to full employment.  In normal times, they pursue these objectives by setting short-term interest rates - the rate of interest that banks charge each other for short-term loans (short-term as in overnight or for one-month). If the Fed wants the interest rate to fall, they buy up short-term Treasury bills from banks.  To pay for these T-bills, they credit the banks reserve account at the Fed.  In normal times, these additional reserves allow the banks to lend more money to the economy - meaning that there is a higher supply of loans, and their cost (i.e. the interest rate on your car loan) goes down.

But these are not normal times.  The Fed has very aggressively cut interest rates by buying up lots and lots of short-term T-bills from banks.  They have paid for these by crediting the banks reserve accounts.  The banks have taken these reserves.......and done nothing with them.  The reserves are "piling up" in the bank vault, rather than being loaned out to you to buy a new car or to a business to expand their factory.  (They don't really have piles of physical money, just entries in a computer, but it's more fun to think of the Fed operating like Gringott's in Harry Potter, with little Alan Greenspan-cloned goblins moving mining cars full of gold back and forth.)

So the Fed has driven the short-term interest rate down to essentially 0 percent, but the banks have simply sat on their new pile of reserves.  We do not get the expansion of credit that the economy could use to get economic activity moving more quickly again.

This is a rare problem.  The Fed cannot lower short-term interest rates below zero (imagine if they did - this would be like a bank offering to pay you back $98 dollars in a year if you deposited $100 today - not a good deal).  But the Fed would still like to generate more economic activity by driving down interest rates. 

The interest rates that tend to matter to you and me are long-run rates like a) mortgage rates, b) car loan rates, c) student loan rates, d) long-run Treasury bonds (because they matter for retirement accounts and influence stock returns).  So the Fed is going to try to more directly affect long-run rates.  They're going to start by buying up T-bonds, mortgages, and packages of car loans and student loans.  Their increased purchases raise demand for these products, which raises their price.  If the price of a bond or mortgage goes up, the effective interest rate on bonds and mortgages goes down.  The Fed is trying to drive down the rates available on new loans and mortgages, so that you, me, and firms will undertake new investment projects (like re-doing your kitchen or building a new factory).  If we start doing this, it drives up demand for goods and services and the economy recovers. 

2) Why might you care?  Well, for one you can probably score lower rates on any new loans.  So buying a new car or house just got less expensive.  That's pretty cool. 

Perhaps more of an issue is that this quantitative easing contains within it the seeds of higher inflation. Why is this?  Well, the Fed is going to buy up lots of bonds and mortgages.  How do they pay for this?  They "print" money.  Bernanke doesn't literally call down to the boys in the basement and yell "fire up the presses!!".  He "prints" money by crediting the bank acounts of those people from whom it bought the securities. 

So this is similar to just printing about $1.2 trillion in new dollar bills and spreading them around.  Now in a slack economy like the U.S., this should increase economy activity rather than drive up prices.  But if the Fed printed too much money (and they don't really know what the "right" amount is) then some of this additional money will simply go towards driving up prices. 

Why do you care about inflation?  No, not because it makes things more expensive.  Inflation is a general increase in prices, and that includes wages.  So inflation by itself doesn't necessarily make you worse off.  In fact, if you are like me and a) young (ish) and b) in debt, then inflation can actually be good for you.  Those mortgage payments don't rise with inflation, but wages do. So in the long-run, big inflation can actually make me better off.

The problem with potentially high inflation is that it generates uncertainty about the future (how long will my dollars be worth anything?) and therefore tends to stifle economic activity and - perversely - will generate higher interest rates in the long-run.

So you should be worried that the Fed is going too big and too strong, and will ignite large inflation rates that will screw us over in the long-run.  At this point, I can see why the Fed is willing to make this kind of bet.  But it is a bet - not a certainty.  This could go wrong.  My first gut reaction, though, is that this will not turn us into Zimbabwe or Weimar Germany (i.e. places with 1000% inflation rates).