The Federal Reserve's Quantitative Easing: Questions and Answers

Recently, the Federal Reserve announced plans to resume monetary easing by purchasing $600 billion in U.S. Treasury bonds by June 2011. Bonds purchases give the sellers additional funds in their banks, which adds to banks' reserves and lending ability. The Fed's goal is to expand money and credit and thereby stimulate the economy, says Robert McTeer, a distinguished fellow at the National Center for Policy Analysis, former member of the Federal Open Market Committee (FOMC) and former president of the Federal Reserve Bank of Dallas.

If short-term interest rates are near zero, how is quantitative easing supposed to help?

The purchase of longer term Treasury bonds (as opposed to short-term Treasury bills) may put downward pressure on longer term interest rates.

The Fed hopes that banks will use the new funds to lend more to businesses and consumers.

Didn't the Fed's balance sheet grow dramatically during the crisis, creating lots of bank reserves? How is that not inflationary?

It hasn't been inflationary so far because, with all the turmoil during the financial crisis and the erosion of bank capital, banks have become very cautious, raising their lending standards (even as loan demand has declined) and holding onto excess reserves.

The reserves are excess in the sense that they exceed regulatory requirements, but they aren't necessarily excess in the minds of the bankers.

If the banks are awash in liquidity, or excess reserves, how is adding even more reserves through a second round of monetary easing going to make any difference?

It might not, but economic theory suggests that bank reserves, like most other things, have diminishing marginal utility.

Thus, even if bankers get lots of utility or benefit from present holdings of reserves, even more reserves would add less and less to their utility relative to what could be exchanged for those reserves: namely, more loans and investments.

Source: Robert McTeer, The Federal Reserve's Quantitative Easing: Questions and Answers, National Center for Policy Analysis, November 19, 2010.

For text: http://www.ncpa.org/pub/ba732

For more on Economic Issues: http://www.ncpa.org/sub/dpd/index.php?Article_Category=17

First published by the National Center for Policy Analysis, United States

FMF Policy Bulletin/ 23 November 2010