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Monday, January 3, 2011

Quantitative Easing and the Growth in the Federal Reserve’s Balance Sheet

On November 3, 2010, the Federal Reserve (Fed) announced that it would purchase an additional $600 billion of Treasury securities, an action that has popularly been dubbed quantitative easing or “QE2.” This announcement followed purchases since March 2009 of $300 billion of Treasury securities, $175 billion of agency debt, and $1.25 trillion of agency mortgage-backed securities (MBS). (The agency debt and MBS were primarily issued by Fannie Mae and Freddie Mac.) This report defines quantitative easing as actions to further stimulate the economy through growth in the Fed’s balance sheet once the federal funds rate has reached the “zero bound.” 

In its announcement of QE2, the Fed justified its decision by citing the “disappointingly slow” progress to date toward achieving its statutory mandate of maximum employment and stable prices. By contrast, critics believe that unconventional monetary actions such as QE2 could be destabilizing and ultimately result in high inflation.

There are several ways that quantitative easing can affect the economy. It would be expected to reduce yields on the securities being purchased, and this could have a cascading downward effect on private yields that could stimulate investment spending. Like any monetary stimulus, it could put downward pressure on the dollar, which would stimulate exports and U.S. production of import-competing goods. The initial quantitative easing following the 2008 crisis helped restore liquidity to the financial system, although this channel is arguably not as important now that liquidity has generally been restored. Finally, the direct effect of quantitative easing to date has been to increase bank reserves by over $1 trillion. If banks choose to lend these reserves, it would stimulate economic activity and increase the money supply. But lending has fallen in the past year, and there have been only relatively modest increases in the overall money supply.

Nevertheless, the increase in bank reserves could eventually result in large increases in the overall money supply, which could arguably make it difficult for the Fed to meet its statutory mandate to keep inflation low and stable. The Fed has explored different methods of unwinding quantitative easing if inflationary pressures rose, which have been referred to as the “exit strategy.” One method would be to directly reverse quantitative easing by selling some or all of the additional securities that the Fed has purchased, which would automatically withdraw reserves from the banking system. A drawback to this approach is that large sales of securities would probably involve selling its mortgage-related securities, and this could be destabilizing to a housing market that is still sluggish. Another method would be to raise the interest rate that the Fed has been paying to banks on reserves since 2008 to a level high enough that it would give banks an incentive to keep the funds parked at the Fed rather than lending them out. This approach is largely untested, however, and the associated expenditure could become large relative to the Fed’s overall profits at historically normal levels of interest rates.

Since the Fed remits most of its profits to the Treasury, where these are added to general revenues, both quantitative easing and its unwinding have implications for the federal budget deficit. Since quantitative easing increases the amount of income-earning securities held by the Fed, it would be expected to increase its profits and reduce the federal budget deficit. Indeed, profits increased from $38.8 billion in 2008 to $52.4 billion in 2009. Similarly, unwinding QE would be expected to reduce the Fed’s profits. Some critics have argued that the Fed is monetizing the budget deficit through QE2. The Fed is legally prohibited from purchasing federal debt directly from the Treasury, but Fed purchases of Treasury securities on the open market have a similar effect on the budget deficit as if those purchases were made directly.

Date of Report: December 21, 2010
Number of Pages: 23
Order Number: R41540
Price: $29.95

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