QE2, Good Or Bad?

No, it’s not the ocean liner. It’s the Fed’s second massive asset purchase, this time $600 billion of longer term Treasury bonds ($75 billion per month over the next eight months), just announced this afternoon. QE2 stands for “quantitative easing 2.” QE1 was the Fed’s somewhat forced purchase of $1.75 trillion of mortgage-backed securities during the depths of the financial crisis. Dropping interest rates to zero wasn’t enough to avert the complete seizure of the lifeblood of the economy, its financial system, so the Fed put a lot of dollars in the hands of those financial institutions holding impaired housing assets. This Fed study found that it worked. Now that the economy is growing too slowly to lower the unemployment rate, and inflation remains low, the Fed decided today that QE2 was necessary to get more growth.

Will it work? Yes and No. It should raise short-run growth, but only if this money is put to use by American businesses and consumers. If they fear further weak growth and long-term inflation because the Fed may be unable to unwind these massive liquidity injections fast enough, it could easily end up being saved and invested overseas. So a lot depends upon market and consumer perceptions of whether the Fed picked a large enough liquidity injection to raise growth, but a small enough one to avoid fears of future inflation. The Japanese experience with quantitative easing a decade ago was that it didn’t work very well. See this San Francisco Fed study.

This was a very tough decision for the Fed today. I don’t envy them the task of venturing into uncharted waters with a very leaky boat. If Ben Bernanke has learned one lesson from his studies of the Depression, it is that policymakers consistently underestimated the problem. I would note that the Fed’s job will be made a lot easier if Congress and President Obama embark on some serious deficit reduction to take effect in 2012 and beyond.

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