UCSC ECON 130 - The Downside of Quantitative Easing

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Economic SYNOPSESshort essays and reports on the economic issues of the day2010■Number 34At its November meeting the Federal Open MarketCommittee (FOMC) decided to engage in a secondround of quantitative easing called QE2 (i.e., quan-titative easing in the form of large-scale purchases of U.S.Treasury securities) by purchasing an additional $600 bil-lion in longer-term government securities by the end of thesecond quarter of 2011. In a recent Economic Synopses essay,I reviewed the transmission mechanism of monetary policyto evaluate the potential effectiveness of QE2.1That analysissuggested several reasons why QE2 might have little or noeffect on output, employment, and inflation or inflationexpectations. This essay analyzes several potential dangersassociated with the FOMC’s previous quantitative easingactions that will be exacerbated by the decision to expandits portfolio further.2The first potential danger is that quantitative easingincreases the likelihood that long-run inflation couldincrease well above the FOMC’s implicit inflation objectiveof about 2 percent. As a result of the Committee’s previousquantitative easing measures, banks currently hold about$1 trillion in excess reserves. As I have noted elsewhere,the supply of money (M1) can be increased massively witha relatively small reduction in excess reserves because theeffective reserve requirement is at a historically low level.3Hence, the current level of excess reserves could create amassive increase in the money supply should banks signifi-cantly increase their lending or investing. QE2 only increasesthis potential. Few analysts doubt that such a massiveincrease in the money supply would be inflationary.Currently, banks are content to hold massive amountsof excess reserves. There are a number of possible reasonsfor this, including (i) weak loan demand associated withregulatory and cost uncertainty and a somewhat anemicrecovery; (ii) capital ratios below their desired or requiredlevels; and (iii) unprofitable lending due to interest rates ator below the cost of capital, thereby encouraging banks tohold excess reserves rather than make loans.4The impedi-ments to bank lending will surely dissipate as the economyrecovers. Should banks begin to significantly expand theirlending and investing, the FOMC would have to takeextreme actions to avoid a marked acceleration in moneygrowth. The FOMC has two options. They can reducethe supply of excess reserves by selling large quantities ofsecurities (either through outright sales or by continuouslyrolling over temporary sales using reverse repurchase agree-ments [repos]). Alternatively, the FOMC could increasethe interest rate it pays banks to hold excess reserves to alevel competitive with the risk-adjusted rate banks couldearn by making loans and investments—thereby preventingthe money supply from increasing.5If the Fed can remove the reserves when the time comesor neutralize their effect on the money supply by payingbanks interest to hold them, why do they constitute sucha serious inflation risk? I believe there are at least fourreasons. The first is that, historically, there has been a lagbetween accelerations in money growth and subsequentinflation. Consequently, inflationary pressures associatedwith excessive money growth could build before the FOMCeither sells securities and/or increases the interest rate itpays on excess reserves sufficiently to significantly curtailmoney growth.A second reason is the considerable disagreement amongeconomists and policymakers about whether and to whatextent money growth per se is inflationary. In the macro-economic model commonly used in analyses of monetarypolicy, inflation is determined by inflation expectations andthe gap between actual and “potential” output. The outputgap is currently estimated to be very large and negative,so proponents of this model are unlikely to be concernedabout rapid growth of the money supply until inflationbegins to increase. Even then, the rise in inflation can ini-tially be attributed to special factors (e.g., an increase inThe Downside of Quantitative EasingDaniel L. Thornton, Vice President and Economic AdviserCurrent excess reserves could create a massive increase in the money supply if banks significantlyincrease their lending or investing.oil prices that could be viewed as temporary) and not apersistent rise in inflation above the FOMC’s inflation objec-tive. This possibility further increases the likelihood thatthe FOMC may be slow to respond.A third reason for concern is that employment growthis uncharacteristically slow during this recovery. At 15months past the recession’s end, employment is only slightlyabove its post-recession trough. Consequently, employmentlikely will remain below its pre-recession peak much longerthan it did after either of the two previous recessions.6Ifemployment remains significantly below its pre-recessionpeak and the unemployment rate stays historically high,the FOMC may be particularly reluctant to move quicklyif money growth were to accelerate sharply or, perhaps,even if inflation were to rise somewhat above its implicitinflation objective. A fourth reason is related to the third. Specifically, theFOMC may be concerned about the adverse effects on thefinancial market from selling large amounts of governmentsecurities quickly. This concern will make the FOMC lesslikely to engage in large-scale asset sales and is likely to beintensified if employment growth is slow and the unemploy-ment rate high.Of course, the FOMC could attempt to impound theexcess reserves by paying market interest rates to banksfor holding them. However, this could be very expensiveand significantly reduce the Fed’s earnings. Indeed, becausethe banks would be making loans that are not default-risk-free while the Fed would be earning interest on default-risk-free government debt, it is possible that the Fed would haveto pay a higher rate to entice banks to hold reserves thanit would earn on its holdings of government securities.More over, paying banks a large amount of interest to holdreserves might be viewed as providing banks with an unwar-ranted and undeserved subsidy.Given that additional quantitative easing may haveonly modest effects on economic growth, employment, orinflation and the potential to significantly exacerbate theFOMC’s problems when the time comes to restore its bal-ance sheet to a more normal configuration, it is easy tounderstand the considerable


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