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.

Fed Currency-Swap Lines – Liquidity for the World

In a press release on September 18, the Federal Open Market Committee announced a $180 billion expansion of the swap lines with foreign central banks, including Bank of Canada, the Bank of England, the European Central Bank (ECB), the Federal Reserve, the Bank of Japan, and the Swiss National Bank. The line has resulted in a decline in the inter-bank overnight lending rate amidst uncertainty of the assets in the counter-party bank. The Federal Reserve Bank of Atlanta provides detail on the swap mechanics.

What does this mean for the US Dollar? Empirically it may be difficult to disaggregate the increased liquidity for US Dollars in foreign markets and the impact on exchange rates from the other, more newsworthy, actions by the US Treasury. European markets saw a substantial decline in the overnight LIBOR (3.843% vs. 5.031%). In this case, many financial institutions did not have access to US Dollar overnight lending and the ECB first auction resulted in substantial demand ($101 billion for the $40 billion offer). The demand was not as strong at the BofE or the Swiss Bank as the central banks have varying collateral standards. Injection liquidity into the market is often an inflationary move, but in this instance it may prove to counterbalance a deflationary Wall Street characterized by tight lending practices, shrinking balance sheets, and cash hording.

Roughly twelve months ago, Former Governor Frederic S. Mishkin noted in his speech, “Systemic Risk and the International Lender of Last Resort”, that the lender of last resort was to provide the following: “(1) restore confidence in the financial system by quickly providing liquidity, (2) limit moral hazard by encouraging adequate prudential supervision, and (3) act as a lender of last resort infrequently.” While the speech was focused more heavily on emerging market economies, it does point out that the injection of liquidity will come with increased regulatory scrutiny (point 2) in order to restore the confidence of market participants (point 1). We all need to hope the injections come infrequently (point 3) and Wall Street, Bay Street, and City of London return to order soon.

UPDATE: At 1:00am EDT September 24 the Fed announced an additional $30 billion of swap lines have been established with the Reserve Bank of Australia, the Danmarks Nationalbank, the Norges Bank (Norway), and the Sveriges Riksbank (Sweden). The Fed will provide up to $10B to each Australia and Sweden and up to $5B each to Denmark and Norway.