Since the financial crisis of 2008, policymakers have attempted to stabilize and stimulate the economy by lowering interest rates, increasing government spending, providing corporate bailouts, and introducing to the U.S. economy the first round of quantitative easing (QE1) measured at $1.25 trillion. QE1 was a monetary policy tool employed by the Federal Reserve with the goal of increasing the supply of money through purchases of Treasuries, mortgage-backed securities, and debt backed by government sponsored enterprises such as Fannie Mae and Freddie Mac. Drawing from a supply and demand framework, Fed purchases are intended to put downward pressure on interest rates with the hope that “cheaper money” will increase both consumer spending and business investment.
Despite QE1, the unemployment rate remains around 9.6%, and measures of underlying inflation are nearly half of the 2% that is targeted by the Fed. As a result, the Fed recently deployed QE2 with a focus on the purchase of longer-term Treasuries. While the Fed normally conducts monetary policy by buying short-term debt, it must now buy longer-term debt as short-term interest rates are already near zero. The plan is to buy up to $600 billion from banks by the end of 2Q 2011, averaging $75 billion per month. Because the purchases will be made from banks, the Fed will credit them with cash to be added to the banks’ excess reserves. This carries with it the hope that banks will then lend excess capital to businesses and consumers.
Most of the controversy around QE2 centers on concerns that the Fed won’t be able to inject enough capital into the system to inflate the economy and lower the unemployment rate without spurring substantial inflation. In response, Fed Chairman Ben Bernanke stated in a recent interview with 60 Minutes, “We’ve been very, very clear that we will not allow inflation to rise above 2% or less. We could raise interest rates in 15 minutes if we have to. So, there is no problem with raising rates, tightening monetary policy, slowing the economy, reducing inflation, at the appropriate time.”
While the broad stock market is up over 10% since Bernanke first broached the idea of QE2 at the Fed’s annual symposium in August, the initial purchases have not yet produced the economic growth sought, nor the inflation many feared. One possible explanation for this is that banks remain reluctant to lend to all but the most worthy borrowers. The Fed has made it clear from the onset that the $600 billion plan may not be enough and more purchases could be in the offing. Time will tell if QE3 will become the next buzzword in the summer of 2011.