Quantitative Easing – Fed to buy $300 billion Govt Securities

With the target interest rate near zero, the Federal Reserve shifts its main policy tool to quantitative easing. Quantitative easing is a policy tool of central banks to inject liquidity through open market operations or outright printing of money. On March 18, often dissenting Richmond Fed President, Jeff Lacker, finally got his way, the Federal Reserve announced the purchase $300 billion long-term treasury securities. At the January 28 FOMC meeting, Lacker cast the lone dissenting vote, Lacker “preferred to expand the monetary base at this time by purchasing U.S. Treasury securities rather than through targeted credit programs.” Despite the Federal Reserves best efforts and a target rate near zero, the US monetary base was actually shrinking during the first quarter of 2009. Federal Reserve Bank of St. Louis working paper by R.G. Anderson nicely defines monetary base as follows:

The monetary base in monetary economics is defined and measured as the sum of currency in circulation outside a nation’s central bank and its Treasury, plus deposits held by deposit-taking financial institutions (hereafter referred to generically as “banks”) at the central bank. More generally, the monetary base consists of whatever government liabilities are used by the public to purchase and sell goods and services, plus those assets used by banks to settle inter-bank transactions.

The monetary base exploded starting with the stimulus package in late 2008 at a rate unparalleled in the past 50 years.


However at close examination, the monetary base has been declining of late.


A shrinking monetary base is commonly thought of as a deflationary sign, during Japan’s Lost Decade, the Bank of Japan kept its target rate near zero and allowed the monetary base growth to slow dramatically following substantial growth during the 1980s. This policy action from 1990-1993 added substantially to the destructive deflation of the decade.

Central banks typically have three policy tools, (1) adjusting the discount rate, (2) adjusting the reserve requirement, and (3) purchase securities via open market operations. Open market operations impacts the monetary base (money supply) as follows, the central purchase securities from consumers and institutions there by injection liquidity (cash in the pocket of consumers) leading to an increase in the monetary base (currency), a component of money supply. It is thought that the US is facing a liquidity trap, an economic condition when target rates are near zero (option 1 no longer available) and the central bank attempts to inject liquidity; however, financial institutions are unwilling to lend.

The Fed’s action to purchase $300 billion in long-term government securities should help mitigate the liquidity trap as well as increase the monetary base, reducing the risk of destructive deflation. Most obviously, there will be an increase in currency in circulation through the purchase of treasurys. Additionally, the purchase of long-term government securities dramatically increased the demand for out-of-favor long-term instruments, thereby flatting the yield curve and reducing the rates on credit with similar, longer-term maturities. The key is a reduction in borrowing costs for end-users, mortgages and retail credit; on cue, US mortgage rates fell to 4.85%, the lowest on record. A reduced rate will hopefully increase demand for credit, in turn prudently expanding the balance sheet of financial institutions.

The action does not come without major skepticism from economists focused on inflation, not deflation as the major concern. Interestingly, while a supporter of the policy, Lacker discussed inflation as a potential concern in his speech to business leaders in Charleston. The expansive Fed balance sheet could prove difficult to unwind when the recession end; Lacker noted that skillful central bankers will be required. While inflation, even hyper-inflation could be a concern with the central bank monetizing the debt like a developing nation, the Fed will have far more tools in the tool kit to fight inflation than deflation. The recent announcement should prove timely and coordinated with the Treasury’s initiatives to clean financial institutions balance sheets.