Quick Thoughts On QE2

Posted in Economics, Financial Markets, Politics and Policy at 8:57 am

Lots of talk out there on the Fed readying QE2 (a second iteration of Quantitative Easing).

It seems to me that QE2 would take one of two forms (or some combination thereof).

  1. The Fed starts buying 10yr and 30yr Treasuries in order to nudge down long term interest rates on mortgages and business loans.
  2. The Fed resumes its purchasing of MBS (it purchased $1.25 trillion late last year and early this year, but completed the program in the Spring).

The problem with #1 is that while it would lower long term rates to some degree, it would also flatten the yield curve.  A flatter yield curve means lower bank profits, and the banks are still in a somewhat precarious state, so this would likely mean less lending.  The problem with #2 is that the Fed’s ultimate goal is to make the mortgage origination and securitization markets self-sustaining (they’re currently on government life support) and additional purchases in this market would be contrary to that goal.

There are no easy answers here.  QE is great in theory, and it really SHOULD work.  Bernanke’s “helicopter speech” gets endless cites in the press.  The problem is that the Fed cannot, literally OR figuratively, drop money from helicopters.  Yet, in a sense, that is exactly what needs to happen – the new money created needs to be put into the hands of consumers and businesses, not kept as excess reserves by banks.  Unfortunately, the Fed has no legal authority to provide the new money to anyone other than banks.  However, the banking system is broken, and the new money being created is just sitting as excess reserves and not making it to the real economy.  A quandary indeed.

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