Last Thursday, the Federal Reserve announced the conclusion of its Large Scale Asset Purchase program, commonly known as Quantitative Easing. Quantitative Easing, or QE, is an unconventional monetary policy tool used by the Fed in response to the Great Recession. QE leaves a mixed legacy. On one hand, it boosted the American economy, reduced unemployment, and prevented a deflationary spiral. On the other hand, it exposed our economy to a number of systemic risks.
The Fed typically conducts monetary policy with “conventional” tools. The goal of conventional monetary policy is to influence economic output through the manipulation of real interest rates. Real interest rates impact economic performance by determining the cost of borrowing, the availability of credit, consumer wealth, and foreign exchange rates. Conventional policy cannot directly control real rates, but it can influence them through the Federal Funds Rate. The Federal Funds Rate, or FFR, is a short term interest rate at which depository institutions exchange bank reserves held at the Fed. When the Fed changes the FFR, real interest rates throughout the economy follow suit. Conventional policies include open market operations, reserve requirements, and discount window lending.
The Federal Reserve responded to the onset of the Great Recession with conventional policy. Through open market operations, the Fed pushed the FFR down to zero by late 2008. Unfortunately, this did not sufficiently stimulate the economy. Conventional policy could not provide any further accommodation because the FFR was stuck at a zero lower bound. In response, the Fed turned to unconventional policies such as forward guidance and Large Scale Asset Purchases (LSAPs).
Large Scale Asset Purchases, known outside the Fed as Quantitative Easing, are large scale purchases of financial instruments by the Federal Reserve. The goal of these purchases is to lower a wider range of interest rates than those directly impacted by the FFR, and to decrease credit spreads. A credit spread is the difference between the riskless short-term rate (FFR), and the rate on any other private debt instrument. Credit spreads account for longer borrowing terms and higher risk. They are important because the rates on longer term and riskier securities are the ones that directly impact economic activity. Credit spreads increased during the Recession. During the first round of QE the Fed purchased $1.25 trillion of mortgage-backed securities. This lowered the spread between short-term borrowing rates and long-term mortgage rates and made purchasing homes more affordable. The Fed followed this with two more rounds of QE.
Quantitative Easing succeeded in reducing a wide range of interest rates. It decreased spreads between short term and long term borrowing, and risky and safe assets. QE made corporate borrowing and home ownership more affordable, stimulating demand in both markets. QE also accelerated the recovery in output and employment. Unemployment is almost at pre-recession levels, and economists have seen decent growth in output. However, QE’s impact on inflation has seen mixed results. Inflation remains below the Fed’s goal of 2%, though QE prevented a deflationary spiral.
A difficulty in measuring the benefit of QE is separating its impact from a broader recovery. In other words, would we have seen the same recovery without QE? The data suggests that the recovery would have been less robust without LSAPs. Conventional policies were unable to sufficiently lower real interest rates due to wide credit spreads and the zero lower bound constraint. Stefania D’Amico estimated that the first and second rounds of QE were comparable to cuts in the FFR of 1.4 and 1.5 percentage points, respectively. QE allowed the Fed to continue being accommodative with an FFR at zero.
Quantitative Easing also exposed our economy to a number of structural risks. QE has driven a considerable boom in asset prices. The S&P 500 has more than recovered from its slide during the recession, and may be overvalued. One useful measure of stock prices is the ratio between the price of the stock and the company’s earnings. This ratio is historically elevated, but has not yet reached the levels seen before the crash in 2008. There is also an inherent inflationary risk to QE. QE reduced rates so much that banks are now voluntarily holding excess reserves at the Fed. The amount of excess reserves has increased from virtually nothing in early 2008 to $2.7 trillion in September, 2014. This poses an inflationary risk because banks may flood the markets with reserves when borrowing rates increase. This danger can be ameliorated if the Fed pays interest on these reserves. This would prevent them from flooding the market when rates inevitably rise. Quantitative Easing also dramatically increased the size of the Fed’s balance sheet, which is more leveraged than ever before. The Fed must shrink its balance sheet, but this will happen inevitably as the assets purchased during QE reach maturity.
Despite the inherent risks of Quantitative Easing, it was necessary to pull the American economy out of recession. If the Fed had stuck to conventional policy, credit spreads would have remained elevated and it is possible that the US would have slid into a deflationary spiral. The Fed must now focus on the systemic risks created by QE.