QE2 was once a cruise ship; now it’s shorthand for another convoluted shift in the Fed’s approach to monetary policy.
The Fed generally prefers to conduct monetary policy by setting an interest rate target. It usually buys or sells short-term securities to hit its target. If Fed members believe the economy needs more money, they buy more short-term securities, raising the price of those securities and lowering interest rates until they hit the target rate.
If the Fed sets the wrong interest rate target, however, the economy ends up with either too much money or not enough. This happened in the summer of 2008. The Fed assumed a 2 percent fed funds rate represented an easy-money policy. They were wrong. The Fed was actually reducing bank reserves and tightening monetary policy.
The St. Louis Federal Reserve data on bank reserves (adjusted for reserve requirements) was actually about 3 percent lower in the summer of 2008 than it had been 3 to 4 years earlier. By this measure, the Fed had produced the most restrictive monetary policy since the early 1930s.
In the fall of 2008, as spending began to collapse, the Fed shifted gears. It began aggressively buying $1.5 trillion in government securities in an effort to ease monetary policy. These purchases of government securities have been referred to as quantitative easing, since the policy focus was on the quantity of securities bought rather than on a target interest rate.
Given the massive purchases of government securities, Fed members believed they had pursued a “highly accommodative” monetary policy over the past two years. They are puzzled over why their purchases of securities have not led to a strong boost in consumer] spending.
Instead of attempting to solve the apparent puzzle, Fed members opted for a second round of quantitative easing—QE2 At their meeting in November the Fed announced it intended to buy $75 billion of longer-term securities each month for the next six months. The Fed members hope the added $600 billion of purchases will ignite spending.
It’s important to place this $600 billion figure in perspective. Until two years ago, the Fed’s entire purchases of securities since it began operating in 1914 amounted to less than $500 billion.
Funds in Reserves
The reason the massive securities purchases of the past two years failed to send either the money supply or consumer and business spending soaring is that most of the funds didn’t get into the economy. Instead, banks chose to keep most of the increase in reserves on deposit with the Fed. So long as banks keep reserves on deposit with the Fed, those reserves cannot be used for loans or investments and cannot increase bank deposits. Hence, they cannot add to the money supply or boost spending.
Holding excess reserves on deposit with the Fed is similar to the Fed raising reserve requirements. If the Fed had raised reserve requirements by $1 trillion, it would be necessary to subtract those “required” reserves from total reserves to calculate the reserves available for expanding bank loans and deposits.
The impact on money and spending is no different when banks choose to keep newly created reserves on deposit with the Fed. This is why neither the money supply nor spending has soared over the past two years.
Subtracting reserves that banks hold with the Fed from adjusted total reserves shows reserves in the banking system have increased by 10 percent from the third quarter of 2008 to the third quarter of this year. During the same period, bank deposits (checking accounts and small time deposits) have also increased by 10 percent. Hence, for the past two years the average growth in bank deposits has been roughly 5 percent a year. This is very close to the pace of spending this past year.
If Fed members had realized monetary growth was this moderate, they would understand why the pace of spending has also been relatively moderate. They also might have been less inclined to experiment with huge additional purchases of securities.
Given the Fed’s operating procedures, it’s impossible to determine the impact of QE2 on monetary policy. The Fed may decide to sell short-term securities to offset its purchases of longer-term securities. This would negate any monetary stimulus. Also, banks could affect the level of reserves by choosing to hold more or less of their deposits at the Fed. Finally, the Fed tells us it may reassess its purchases at any time. The sharp rise in longer-term interest rates since the Fed began QE2 may lead to such a reassessment.
The huge changes in the Fed’s balance sheet over the past two years have brought only a moderate increase in the money supply. Fed members (and others) believe they have increased the money supply significantly. They have not. Instead of trying to understand the monetary process, they have turned in desperation to experimenting with QE2.
Without a better understanding of the impact of its actions, the Fed’s latest policy shift will continue the confusion and mismanagement of monetary policy that has been so prevalent in recent years.
Robert Genetski ([email protected]) is a Heartland Institute policy advisor and runs classicalprinciples.com, which provides financial guidance using classical economic and investment principles and where an earlier version of this article appeared. Used with permission.