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What is QE2? Understanding the Fed's latest monetary policy moves

photo of FOMC meetingThe Federal Open Market Committee (FOMC) voted on Nov. 3, 2010, to institute another round of large-scale asset purchases, often referred to as QE2. "QE" stands for quantitative easing, and the "2" reflects the fact that this is a second round of such large-scale asset purchases. In pursuing this policy, the FOMC has said it intends to purchase $600 billion of U.S. Treasury securities over eight months at approximately $75 billion of Treasuries per month. The Treasuries being purchased have longer-term (mostly five- and 10-year) maturities. The possibility that the FOMC would implement additional monetary policy action was first raised in a speech by Federal Reserve Chairman Ben Bernanke at the Federal Reserve Bank of Kansas City's Economic Symposium on Aug. 27, 2010, and was further indicated by the FOMC's decision in August to reinvest the principal from all its maturing securities holdings.

According to its policy statement, the FOMC is purchasing these assets "to promote a stronger pace of economic recovery and to help ensure that inflation, over time, is consistent with its mandate" of fostering maximum employment and price stability. The FOMC also said that its purchases will be routinely monitored as new economic data become available, and the Committee can adjust the purchases as necessary.

The FOMC is the group within the Federal Reserve charged with setting the nation's monetary policy. In November, the FOMC decided to leave its target for the federal funds rate at a range of 0 to 25 basis points. The Committee said it expects this accommodative interest rate policy to persist for an "extended period." This policy should help keep shorter-term financing costs relatively low. However, with short-term rates near zero, there is no scope for traditional monetary policy tools such as the federal funds rate to provide additional support to the economic recovery.

A number of critical factors influenced the FOMC's November decision to purchase additional longer-dated Treasury securities. In a Nov. 16 speech to the Alabama World Affairs Council in Montgomery, Ala., Atlanta Fed President Dennis Lockhart cited economic data from the second half of 2010, which showed signs of a slowing recovery and a disinflationary trend. Most indicators of underlying consumer inflation trends have been drifting lower, and financial market data suggested that the risks of outright price deflation had increased. By summer 2010 there were concerns about the potential of "tipping into a deflationary dynamic," according to Lockhart. Other troubling indicators mentioned in the FOMC statement were constraints on household spending from high unemployment, tight credit, and lower housing wealth, in addition to weak investment in nonresidential structures. Also, employers continued to be reluctant to expand their payrolls, while real estate markets remained depressed.

Various observers have said that an inherent risk associated with the large-scale asset purchases involves the potential to create too much inflation. The Fed's credibility could be compromised if this outcome occurs. However, as Bernanke said in his Aug. 27 speech, "the Federal Reserve has expended considerable effort in developing a suite of tools" to implement a successful exit from the expansionary policy. As mentioned above, the FOMC stands ready to adjust the purchase program and other policy tools in light of incoming information about economic conditions and inflation trends.

Some critics claim the asset purchase policy amounts to monetizing the federal debt. Lockhart countered that such an action would involve the Fed tying "its purchases to new Treasury debt issues…to enable the government to finance near-term deficits and/or eventually inflate away some of the nominal value of government debt. This is not the objective." Instead, he reiterated the Fed's policy of continued support for economic recovery coupled with the goal of achieving the FOMC's longer-term price stability objective.

Others allege that a devaluation of the dollar is the Fed's motivation. Lockhart addressed this concern by emphasizing that monetary policy actions always affect a wide variety of assets, and while monetary easing can influence the prices of some assets, the efficacy of quantitative easing is not explicitly tied to dollar depreciation.

Still others believe that the asset purchases will not generate its goals of sustainable economic expansion along with low and stable inflation trends. James Bullard, president of the St. Louis Fed, emphasizes that there is a traditional lag of anywhere from six to 12 months for discernible real effects to be observed in the economy, and those effects are inherently difficult to disentangle from other forces at work in the economy. In his presentation "QE2 in Five Easy Pieces," Bullard argued that "while asset purchases are sometimes viewed as unconventional, the financial market effects have been entirely conventional." For example, equity prices rose and inflation expectations stabilized, while real (inflation-adjusted) interest rates declined and the nominal value of the dollar depreciated, all in advance of the November FOMC meeting because the financial markets had already priced in the likelihood of additional large-scale asset purchases.

As noted in its policy statements, the FOMC remains committed to using its policy tools as needed to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate. Ultimately, as economic conditions improve sufficiently, the FOMC's accommodative policy will begin to be reversed. For that reason, the FOMC continues to closely monitor evolving economic and financial conditions.

By Amy Hennessy, economic and financial education specialist, Public Affairs

January 27, 2011