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How to think about QE2

By Karl Smith

I am continually amazed at how monetary policy seems to get otherwise smart people twisted in knots. Here is the typically sharp Reihan Salam:

Felix [Salmon] has written a measured post on the potential risks involved in QE2. After acknowledging that the grim employment numbers are a good reason to at least consider more monetary accommodation, he observes that this is a very big experiment that could go very wrong. Think of QE2 as the geoengineering of monetary policy.

Or we could think of it as buying bonds -- what the Fed does every day. Here is a snippet from Felix’s original post.

What’s the downside? Well, for one thing, it’s extra fuel for the bond-bubble fire. Treasuries are already highly sought-after securities; this announcement increases the demand for them so much that the Fed has had to “temporarily relax” the limit of 35% of any given bond issue that it’s allowed to buy. With all that money flowing into a constrained asset class, market imbalances are all but certain to result in unintended consequences somewhere down the road.

Now, lets think about this for a second. Felix is suggesting that the Fed buying bonds raises the demand for them. On one level this is true, since the Fed is itself now a buyer and therefore a part of total market demand. However, this raises the price of bonds – a conversely lowers their yield. This should decrease the non-Fed demand for bonds.

Moreover, the idea that fewer non-Fed buyers want to purchase bonds is consistent with the idea that the Fed has to relax the upper limit on how much of the market it can buy.

If there were more buyers, then the Fed’s buying fraction would go down, not up. However, there are fewer buyers; that’s why the Fed has to allow itself to be a larger percentage of total buyers.
We can back up even further and think about monetary policy generally.

Most people are probably pretty familiar with the idea that the Fed raises or lowers interest rates. Yet, how does it do that?

Well suppose the Fed wanted to lower interests rates. The Federal Open Market Committee – which Ben Bernanke heads – issues orders to the open market desk.

Traders at the open market desk are told to start buying bonds. As they do bonds go up and price and the yield or interest rate goes down. The traders are ordered to continue buying until the interest rate hits the committee’s target and then stop.

However, currently interest rates on short-term bonds are basically zero. What are the traders to do? Well, consistent with their orders they simply stopped, and the market halted where it was.

Now, the Fed is issuing a new kind of order. It used to say keep buying until you hit a target interest rate. Now it is saying keep buying until you have spent $75 billion per month. The traders will begin buying as ordered, and instead of stopping when they see a certain interest rate, they stop once they’ve spent a certain amount of money.

Economists like to think in terms of prices and quantities. Usually the orders from the FOMC come in the form of prices, in this case the price is called the interest rate. Now the orders will come in terms of quantities. This is why the whole thing is called quantitative easing. It is a quantity target instead of a price target.

Otherwise, it is the same.

Karl Smith is an assistant professor of economics and government at the University of North Carolina and a blogger at

By Karl Smith  | November 8, 2010; 10:20 AM ET
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Really glad you're posting here Karl, your explanations of monetary policy are lucid. Given that, I want to ask: why is it such a commonplace to assert that a central bank is limited by the zero-lower bound on interest rates? As Krugman, Hatzius, and others have noted, right now conventional Taylor-rule models suggest that the Fed should be targeting a (short term) interest rate of -6%, but since it can't get there (bound by 0) it needs to shift its activity to further down the yield curve. But since the "interest rate" in question is not the coupon-divided-by-the-face-value of a note, but rather the discounted-present-value-of-future-coupon- and-redemption-payments-divided-by-the-market price of a note, why can't the fed target a negative interest rate by paying more for notes (or other instruments) than their future-coupon-and-redemption payments? If the Fed is paying $15K for a $10 face value 30 day note, how is that not a negative interest rate? You'd still have the issue of getting such money into circulation, and I suppose what I'm describing here is essentially the helicopter drop, but I've been really puzzled by this.

Posted by: rwclayton7 | November 8, 2010 12:31 PM | Report abuse

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