QE2 Is Likely to Be More Successful than QE1

QE2 Is Likely to Be More Successful than QE1
November 4, 2010

by Paul Kasriel and Asha Bangalore, Northern Trust

On November 3, the FOMC announced that it would increase the quantity of its outright holdings of securities by a net $600 billion by the end of the second quarter of 2011. Thus, the Fed has re-embarked on a policy of quantitative easing. Its first real “voyage” of quantitative easing, QE1, started at the end of November 2008 and ended in March 2010. The expected (hoped for?) outcome of a quantitative -easing policy is increased nominal demand for goods and services. Under normal circumstances when the commercial banking system is not constrained by actual or expected capital inadequacy, the Fed is able to stimulate the nominal demand for goods and services by lowering its key policy interest rate, the federal funds rate. The federal funds rate is the one-day cost of immediately available funds in the financial system and, therefore, represents the marginal cost at which banks can fund themselves. As banks’ cost of funds goes down, due to competition, banks pass on their lower cost of funds to their loan customers. The decline in loan rates leads to an increase in the quantity demanded of bank credit. The increase in bank credit supplied leads to increased nominal spending on goods, services and assets. When the banking system is constrained by actual or expected capital inadequacy, banks collectively are unable to increase their supply of credit even though their marginal cost of funds has fallen. This actual or expected banking- system capital inadequacy has been hampering the effectiveness of the Fed’s low interest-rate policy in stimulating the nominal demand for goods, services and assets. Thus, the Fed is now turning to a second round of quantitative easing.

There has been much misinterpretation in the media of how quantitative easing “works.” Indeed, we are not sure that even the Federal Reserve fully understands how quantitative easing works. The typical explanation of how quantitative easing works is that the Fed’s purchases of longer-maturity securities will bring down the interest rates on these securities. The lower interest rates on longer-maturity securities will then induce the nonbank private sector to borrow and spend more. Also, the lower interest rates on longer-maturity securities will make equities more attractive investments at the margin, thereby causing a rally in equity prices, which, in turn, will induce the private sector to increase its current spending on goods and services via a wealth effect. Lastly, the lower interest rates on longer-maturity securities and the expectation that the Fed will hold short-term interest rates at a very low level for a extended period of time will weaken the foreign –exchange value of the dollar, thereby making U.S. exports more price competitive in global markets. All else the same, we do not dispute that interest rates on longer-maturity securities would fall, that equities would become more attractive and that the foreign-exchange value of the dollar would decline with the implementation of quantitative easing on the part of the Fed. What we do dispute is that these are the main channels through which quantitative easing operates to stimulate the nominal demand for goods, services and assets.

Have you noticed by now that whenever we mention quantitative easing, we italicize quantitative? We have done this to emphasize that the main channel through which quantitative easing stimulates the nominal demand for goods, services and assets is through the quantity of credit created by the combined Federal Reserve System and commercial banking system, not the price of credit (the interest rate), not the price of equities and not the price of foreign exchange. If one were to review Econ 101 text books, one would discover that central banks are able to create credit figuratively “out of thin air.”

The important implication of this is that the recipients of central bank-created credit are able to purchase goods, services and assets without any other entity in the economy having to cut back on its current purchases of goods, services and assets. The Federal Reserve, of course, is the U.S. central bank. If one were to read a little further in the Econ 101 text, one would discover that the commercial banking system, not an individual bank, also is able to create credit figuratively “out of thin air,” providing that the central bank supplies the “seed money” for this to the commercial banking system. The important implication of the creation of credit by the commercial banking system, is the same as that of the creation of credit by the central bank: the recipients of this credit created by the commercial banking system are able to purchase goods, services and assets without any other entity in the economy having to cut back on its current spending on goods, services and assets.

Thus, if combined central bank and commercial banking system credit increases, there is a presumption that current nominal aggregate spending on goods, services and assets will increase. That same presumption with regard to an increase in nominal aggregate spending cannot be made when credit is granted by the nonbank sector. In this case, the presumption is that the grantors of credit will decrease their current nominal spending, transferring purchasing power to the recipients of the credit. Thus, when the nonbank sector extends credit, the presumption is that nominal aggregate spending does not increase. The exception to this presumption would occur if the quantity of currency and bank liabilities desired to be held by the nonbank public were to fall by an amount equal to or greater than the amount of nonbank credit extended.