Since the Fed’s launch of third round of quantitative easing (QE3, aka QE-infinity), I’ve seen several commentaries about whether this intervention was appropriate, why this intervention will either succeed or fail (depending on who is editorializing), and opinions on how to measure the success of the Fed’s actions. As I have read these, none has resonated with me, though many have helped me frame my thinking.
Having just spent a little time thinking about corporate hiring (see here), I am struck that perhaps I have been missing one of the key rationales motivating the Fed.
QE introduces new money into the economy. The fed buys bonds or other assets with the hope that by making yields so low, banks will stop buying bonds and will instead lend money to borrowers who will invest productively. (I’m looking simplistically and not focusing on the many other intentions and side effects of QE, including simply boosting asset prices to create an environment of increased confidence to bolster spending).
Thinking about a different possible outcome, what if the economy enters into a new recession? In this case, businesses would face declines in new orders and some would go bankrupt. Businesses that borrowed might default on their loans. Other enterprises might cut costs which really means additional layoffs. This could lead to more newly -unemployed homeowners unable to pay their mortgages resulting in another bout of foreclosures. Banks would try to sell these foreclosed-upon homes producing excess home supply and further declines in home prices. In this scenario, additional QE would likely prove ineffective. The Fed can lend banks all the money in the world, but, in the face of low demand with businesses going bankrupt, why would banks be eager to loan money? It would be better for banks to keep money in-house with low (zero) return than originate an unsecured loan with a high probability of loss/default.
Prior to the 2008-9 recession, the Fed Funds rate was 5.3% and the Fed’s balance sheet was a fraction of its current size. The current starting point is much different. Cash is already cheap with the federal funds rate at 0%, and the Fed has injected cash into the financial system via the purchase of two trillion dollars of bonds and mortgage-backed securities). While there is always more the Fed can do to push more money into the economy, such activity is not likely to have an effect if banks and individuals cannot put that money to productive use. By this thinking, QE3 might not have much impact if a new recession starts. Therefore, the Fed might have decided to undertake additional stimulus now while such actions still matter.
In an ideal world (some years in the future), we will look back at QE3 as having been foolish on the part of the Fed. In this scenario, there will be no new recession, unemployment will continue to decline, and consumer demand will remain strong. If this comes to pass, we will never know if QE3 was necessary to have achieved this outcome. Though QE3 may ultimately have deleterious side effects, the prospect (or hope) of spurring demand and confidence with the goal of avoiding another recession means that QE3 might actually have been the right course of action for the Fed to take.