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QE2: Answers to four big questions facing the Fed

By Neil Irwin

A month ago, I wrote about four key questions facing the Federal Reserve as it decides what new action to take to boost the economy. Now, we seem to more or less have some answers.

In that piece, I did some hand-wringing about how new efforts to ease monetary policy, while appearing likely, might not happen if the economy showed improvement before the central bank's Nov. 2-3 policy meeting. Since then, the economy has continued on its sluggish growth path, and speeches from Chairman Ben S. Bernanke and Bill Dudley, New York Fed President and vice-chair of the central bank's policy committee, have given every indication that the Fed is prepared to pull the trigger. Indeed, at this point, if the Fed were to decide against taking any action next week, it would cause a major sell-off in global markets and amount to a communications failure of epic proportions.

Below are the four questions I posed a month ago and the apparent answers.

How much 'quantitative easing?' We won't have definitive answer on how many hundreds of billions of dollars in bonds the Fed will purchase until about 2:15 p.m. Wednesday, when the Fed's policy statement comes out. But discussion among Fed watchers -- which the central bank has done little to dissuade -- has centered on a number somewhere around $500 billion. Much lower than that and there could be an adverse reaction in financial markets and a sense that the Fed is moving timidly in response to a faltering economy. Much higher than that would be interpreted as a bold and aggressive action by the central bank, but it would become harder for Bernanke to persuade Fed colleagues who are on the fence to support the action. Remember, this is a chairman who leads by consensus. So given all that, a number between $400 billion and $600 billion seems most probable, although other options can't be ruled out entirely.

Shock-and-awe or dribs-and-drabs? An open question has been whether to announce a massive deployment of cash and then carry out the purchases over time until that numerical total is reached, or announce a much smaller number and then adjust the rate of purchases as time goes by in response to incoming economic data. Fed leaders seem to be settling on something of a hybrid approach, trying to get the benefits of both strategies. On one hand, by announcing a number in the $400 billion to $600 billion range, they would be assuring markets that the bond purchases will ultimately reach substantial levels (if not the $1 trillion-plus numbers that some market participants have hoped for). Yet they would also have the flexibility to adjust the size of purchases as time passes and more economic data come in.

Treasurys or mortgage-backed securities? What assets will the Fed buy to expand its balance sheet and pump money into the economy? In the earlier round of quantitative easing, in 2009 and early 2010, most of the purchases were of mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac and the debt of those two companies rather than Treasury bonds. But Fed leaders this time around seem more inclined toward buying Treasurys, which are viewed as a more neutral way to execute monetary policy, affecting interest rates across the economy simultaneously rather than favoring the housing sector. The biggest tip-off to this approach came in August, when the Fed decided to start reinvesting proceeds from maturing mortgage securities into Treasurys. Since then, Fed leaders have often spoken as if they were assuming that Treasury bond purchases would be their tool of choice in QE2. One possible exception: If the bond purchases ultimately occur on such a large scale that they risk disrupting the Treasury market by crowding out private buyers, then the Fed could broaden its strategy to include mortgage-related securities.

Cut the interest rate on reserves? As recently as August, Bernanke mentioned cutting the interest rate that the Fed pays on the funds that banks keep on deposit at the Fed -- known as reserves -- as a tool to stimulate the economy. That option now appears to be off the table; Bernanke did not mention the possibility in his Oct. 15 speech in Boston. The Fed originally reduced the rate to a quarter percentage point back in December 2008, but officials concluded that lowering it any further could cause technical problems in money markets that wouldn't be worth creating given the minimal economic benefit of an another cut. The preliminary conclusion this time around is that there is no new information -- about either the economy or about the functioning of money markets -- to lead to a reversal of that decision.

Coming soon: Four remaining questions about what the Fed will do next week.

By Neil Irwin  | October 28, 2010; 8:00 AM ET
Categories:  Federal Reserve  
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Comments

no.4 is just idiotic

cut IOR and further QE simply shunts the effective FFR to zero. Thanks for coming.

Further, cutting IOR implies that banks need reserves before they lend. Banks don't need reserves in order to lend. Fact. Anyone who thinks this is true (the media comes to mind) need to get it through their thick heads. It is completly incorrect.

Posted by: Anonymous | October 29, 2010 8:03 AM | Report abuse

To Q or QE2...

Always good to have the consensus challenged.

I can see the emerging rationale that QE2, a sharp jump in broad money supply, should depress the dollar, but two questions:

-why didnt QE1, where the fed bal sht went from $1tr to about $2tr in the space of 2ish years have a dramatic effect on the dollar? Isnt this in simple terms, a doubling of supply which should on a unitary elastic demand curve (keeping it naively simple) lead to a halving in the $ price? IS the answer 'there was a concommitant shift in the demand curve' to result in same'ish price? Is that evident from foreign ownership in $ assets?

-Of the $1 or $2 tr that was QE1, how much found its way in an increase in broad money. My thinking is this: there was so much impairment in assets on bank bal sheets and non-bank finance cos, that a major part of the credit creation simply filled the holes left by the impairments, leading to a far smaller increase in M1 or M3, whatever is the deviant aggregate today.

-it may well become more explicit in the FED's thinking, that a weakening dollar is in the national interest. But to what extent is this thinking beyond their control: if the rest of the world continues to demand dollars (cos there aint no realistic alternative!) why should the $ necessarily decline, even if the FED desires it? So the new world order is such that a sovereign govt DOES NOT have autonomy over its currency, even if they do own the printing press!! I would really appreciate thoughts on the above.

Thank you

Posted by: shah1 | October 29, 2010 12:53 PM | Report abuse

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