The Fed needed QE2 because QE1 didn’t quite work as well as planned. The Fed bought securities from banks to force them to keep rates low. Typically, this would encourage them to lend more money, increasing the money supply and boosting growth. But the banks didn’t increase lending as the Fed wanted them to. Instead, banks held onto the extra credit. They used it to write off foreclosures or saved it in case they needed it. The banks said they couldn’t find enough credit-worthy people after the recession. They didn’t mention that many had raised their lending standards since 2007, hoping to avoid more bad debt. So, the Fed adjusted. In Aug. 2010, It announced it would maintain its holdings at the $2.054 trillion level by reinvesting principal payments on agency debt into longer-term denominations, such as 10-year Treasury notes. In Nov. 2010, it announced the purchase of an additional $600 billion in longer-term Treasurys. Its goal was to keep interest rates low to make housing more affordable. It also wanted to make Treasurys unattractive to force investors back into mortgages.
The Fed Shifted Its Focus With QE2
With QE2, the Fed was trying to spur mild inflation. Why? It wanted to stimulate the economy by increasing demand. When prices rise slowly and consistently over time, people are more likely to buy now to avoid the future price increase. In other words, the expectation of inflation is a powerful driver of demand. The Fed’s target rate of inflation is 2%. The Fed uses the core inflation rate, which excludes volatile gas and food prices, as its measurement tool. Gas prices rise each spring as investors expect increased demand from the summer driving season. Food prices soon follow since transportation costs are a big component of food costs. The Fed doesn’t want to change its monetary policy in reaction to that seasonal shift. That’s why the Fed often uses expansionary monetary policy even when there are no price increases in food and gas. Why did the Fed ignore its primary mandate to avoid inflation? It was more concerned that the sluggish economy would create deflation. This consistent decline in prices is always a bigger threat to economic growth than inflation. The best example of deflation occurred in housing during the recession. It experienced a near 30% deflation in prices. Thanks to deflation, people were hesitant about buying homes until prices started trending up again. Until that happened, deflation kept homebuyers on the sidelines. This allowed housing prices to fall further. Many investors weren’t worried about deflation. They were more afraid the Fed would overshoot its inflation target, creating hyperinflation. For that reason, when the Fed announced QE2, investors started buying Treasury Inflation Protected Securities. Others started buying gold, a standard hedge against inflation. This asset bubble sent gold prices soaring to a then record high of $1,895 an ounce by September 2011. The Fed ended QE2 in June 2011. It increased its balance of securities to $2.6 trillion. Investors would have preferred to see the Fed sell holdings or even raise interest rates. For some reason, they were more worried about inflation than the sluggish economy.
Why Announcing QE2 Was So Effective
Fed Chairman Ben Bernanke had announced QE2 before he began buying. In April 2011, he announced that QE2 would end in June. Bernanke had learned from the success of former Fed Chair Paul Volcker. He understood that setting the public’s expectation of Fed action in advance was as important as the central bank’s action itself. Volcker used this consistency to clean up the stagflation mess created by his predecessors. Their stop-go monetary policy, where interest rates rose and fell unexpectedly, confused the markets. That created an expectation of ever-higher inflation. Businesses just kept raising prices to protect themselves from the Fed’s inconsistent actions. Volcker ended double-digit inflation by consistently setting public expectations of inflation.
Quantitative Easing Before QE2
QE2 was a creative use of an existing tool. The Fed historically used quantitative easing as part of its expansionary monetary policy. It held over $700 billion in Treasurys in the months leading up to the great recession. The Fed used this portfolio to stimulate growth during recessions or slow it down during a bubble. But the financial crisis of 2008 exhausted the other Fed tools. The Fed funds rate and the discount rate were already at zero. The Fed was even paying interest on banks’ reserve requirements. The current Fed interest rates determine the nation’s economic prospects. By November 2008, the Fed realized it needed to step up quantitative easing. It announced the launch of what is now called QE1. This program was innovative. The Fed added massive purchases, worth around $600 billion, of mortgage-backed securities to its regular purchases of Treasuries. By June 2010, the Fed’s securities holdings had set a new record of nearly $2.1 trillion. Thinking the economy was recovering, the Fed cut back on purchases. By August, it reinstated QE1. It reinvested principal payments on agency debt in longer-term Treasurys such as the 10-year note. Other QE Programs: QE3 | Operation Twist | QE4
