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Thursday, December 18, 2008

Some Context on Quantitative Easing and the Enormous Power of the Federal Reserve

A term that is sure to become popular in the world of business analysis soon is quantitative easing.

First, it cut rates once again from the existing one per cent to something close to nothing. But, instead of announcing a target rate for the overnight interest rate – as it has done for the last decade – the Fed said it would aim to keep the rate in a range – between zero and a quarter percentage point. This unusual move reflects the fact that the federal funds rate – a market interest rate that the Fed can move only indirectly – has been volatile recently because of continuing strains in the interbank lending market.

Second, in its statement accompanying the move, it noted that the US economy had
deteriorated on almost all fronts in the last few weeks, and it said that those “weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.”

Here is how Wikipedia defines this monetary tool.

Quantitative easing is a tool of monetary policy. It effectively means that the central bank prints new money, in order to increase the supply of money. 'Quantitative' refers to the money supply; 'easing' essentially means increasing.

Quantitative easing was used notably by the Bank of Japan to fight domestic deflation in the early 2000s. More recently (December 2008), policies announced by the US Federal Reserve under Ben Bernanke to counter the effects of the onsetting recession[1] have been likened to quantitative easing.[2]

In Japan's case, the BOJ had been maintaining short-term interest rates at close to their minimum attainable zero values since 1999. With quantitative easing, it flooded commercial banks with excess liquidity to promote private lending, leaving them with large stocks of excess reserves, and therefore little risk of a liquidity shortage.[3] The BOJ accomplished this by buying more government bonds than would be required to set the interest rate to zero. It also bought asset-backed securities, equities, and extended the terms of its commercial paper purchasing operation. [4

Whereas way back when, central governments would simply print money. Now, they do other things. In this case, the Federal Reserve is doing two things in lieu of quantitative easing. The first is to effectively drop short term interest rates to zero by dropping the Fed Funds Rate to a quarter of one percent. The second is to begin to buy up hundreds of billions of Dollars worth of Fannie/Freddie bonds in order to drive the interest rates down. By cornering the market so to speak on these bonds, by buying up so many, they create all sorts of artificial demand for them. As such, we have seen thirty year mortgages go to nearly unprecedented levels.

Now, let's put this in perspective. By fiat, the Federal Reserve has allowed any bank or other financial institution to borrow overnight or something similar for free. Also, by sheer will, the Federal Reserve has driven down mortgage rates to nearly unprecedented levels. There is no force, no individual, and no office with that kind of power. The ability to single handedly affect short and long term rates is a power that is frankly unimaginable.

Yet, here is the irony. All of this is done to stimulate the economy. While the Fed can pretty much do what it wants to rates of any measure, it is still unclear whether or not it can actually stimulate the economy. That, so far, the Fed has been totally impotent in doing. Such is perspective of the enormous power of the Fed.

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