The Case for Quantitative Easing

It seems likely that the Federal Reserve will initiate another round of bond buying, known as quantitative easing. The move will be controversial. Monetary hawks will accuse the bank of debasing the currency; presidential candidate Rick Perry even stated that doing so would be tantamount to treason. And monetary doves will lament the bank's restraint for not doing more, regardless of how much it does or does not do.

Here at The Motley Fool, we like to have a thorough understanding of issues and their consequences before drawing conclusions. What follows, in turn, is a look behind the scenes at the Fed. I'm seeking to answer what the Fed does, how it does it, and why it may be inclined to step back into the fray by printing even more money.

A primer on the Federal Reserve
Congress founded the Federal Reserve in the aftermath of the Panic of 1907 -- a financial meltdown not unlike the one we experienced in 2008. At the time, massive amounts of United Copper Co. stock had been purchased on margin by a speculator trying to corner the market in the company's stock. When his bid failed, banks that had lent him money suffered runs that later spread throughout the country. In the absence of a central bank to add liquidity to the system, the panic didn't stop until the New York Stock Exchange had fallen almost 50% in value, numerous businesses and banks had failed, and at least one high-profile corporate emergency takeover had been approved by President Theodore Roosevelt -- I told you it wasn't unlike our recent experience!

The Fed's mandate from Congress is to promote maximum employment and stable prices -- commonly referred to as the "dual mandate." As you may expect given the gravity of these goals and the fact that Washington is involved, there's much debate about what these mandates mean. In terms of unemployment, while a consensus appears to have coalesced around a long-term rate of 5%, some economists suggest that it may have risen by 1.7% in recent years. In terms of inflation, on the other hand, while the bank seems comfortable with the present inflation rate of 3.4%, it claims to be committed to keeping long-term inflation at less than 2%.

The Fed uses "three tools of monetary policy" in pursuit of these goals -- the discount rate, reserve requirements, and open market operations. The discount rate is the interest rate charged to banks and other depository institutions on loans they receive from the Fed's lending facility, otherwise known as the discount window. Reserve requirements are the amount of funds a depository institution must hold in reserve against specified deposit liabilities like check accounts, savings accounts, and certificates of deposits. And open market operations, the Fed's primary tool for implementing monetary policy, consist of purchases and sales of U.S. Treasury and federal agency securities on the secondary bond market.

As a general rule, the Fed uses these tools in a countercyclical manner -- driving interest rates up in good times and down in bad times. A textbook example of this occurred in the late 1970s and early 1980s when the Fed increased short-term interest rates to nearly 20% to stymie the double-digit inflation raging at the time. Alternatively, following the attacks on Sept. 11, 2001, and the bursting of the Internet bubble, the Fed drove these same interest rates down to less than 1%. In both cases, the central bank was said to be "leaning against the wind" in its efforts to moderate the cyclical nature of the economy.

Response to the crisis
It isn't an exaggeration to say that the central bank's actions since 2008 are unparalleled in both size and significance. Working with then-Treasury Secretary Hank Paulson and his department, the Fed orchestrated a massive bailout of the financial sector. It opened its discount window to institutions as varied as American International Group (NYSE: AIG  ) , General Electric, and McDonald's. It injected hundreds of billions of dollars of capital and loans into the nation's biggest banks including Bank of America (NYSE: BAC  ) , JPMorgan Chase (NYSE: JPM  ) , Wells Fargo (NYSE: WFC  ) and Citigroup (NYSE: C  ) . It helped orchestrate the acquisitions of Bear Stearns (by JPMorgan) and Merrill Lynch (by B of A) over a couple of adrenaline-fueled weekends. And it bought more than $2 trillion worth of government and mortgage bonds on the secondary market. Add up the guarantees and lending limits, and the Fed had committed $7.77 trillion to the cause as of March 2009, more than half the value of everything produced in the United States that year.

Yet the economy continues to merely limp along. According to the Case-Shiller index, nationwide housing values remain 30% off their 2006 levels. In places like Las Vegas, they're less than half. Robert Shiller even told Fool writer Morgan Housel recently that he wouldn't be surprised if home prices continue to fall for several more decades! And things look similarly grim on the jobs front. Despite a positive report earlier this month, the unemployment rate is 8.5%, and that doesn't count the millions of people who have quit looking for work altogether. With the latter factored in, the rate is probably closer to 16%, some estimates even have it has high as 22%. Though perhaps most telling of all, is the average length of unemployment. In previous recessions, the average duration of unemployment topped out at 20 weeks. It's at 40 weeks as I write!

To ease or not to ease
When you consider that maintaining maximum employment is one of the Fed's mandates, it's no surprise that the central bank is contemplating additional action. Even at the Fed, however, there remain detractors. Namely, those who are worried that additional stimulus will trigger an uncontrollable inflationary spiral akin to the Paul Volcker era. This includes Federal Reserve Bank of Philadelphia President Charles Plosser, who argues that any move to allow inflation to accelerate, regardless of the motivation, is wrong-headed. And Federal Reserve Bank of Minneapolis President Narayana Kocherlakota, who noted that the trade-off between price pressures and long-term unemployment "might well cost us too much" if further easing were put into place.

At the end of the day, however, what these so-called hawks believe is probably irrelevant. With the rotation of the Fed's monetary policy committee set to take place at its next meeting, Fed Chairman Ben Bernanke will have a far more receptive audience to the idea of further quantitative easing. And I strongly suspect, as do others, that he will take full advantage of the situation given his opinion that the Fed's failure to do so was at least partially responsible for the depth and duration of the Great Depression.

Looking for great investing ideas?
Download our recently released free report: "The Stocks Only the Smartest Investors Are Buying." It explains why Warren Buffett and others are interested in banking stocks and even reveals the name of a specific one that we think Buffett would be interested in if he were a small investor. To access this report while it's still available, click here now -- it's free.

Fool contributing writer John Maxfield owns shares of Bank of America. The Motley Fool owns shares of Wells Fargo, JPMorgan Chase, Citigroup, and Bank of America. The Fool owns shares of and has created a covered strangle position on Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (8) | Recommend This Article (14)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 17, 2012, at 8:35 PM, CaptainWidget wrote:

    The Fed only has one tool, the ability to print money. You know what they say "when all you have is a hammer, the whole world looks like a nail".

    If prices drop, it's deflationary. Deflation means there's not enough money, so we have to print more money.

    If prices raise, it's harmful to consumers and total employment. As costs raise, production decreases. In order to ease the burden of producing, the money supply needs to increase to prime demand, so we have to print more money.

    If the federal reserve wanted to increase employment, they'd raise interest rates to encourage savings. If they wanted to keep prices stable, they'd let natural improvement in productivity drop real prices and let the dollar strengthen relative to the value of goods produced in the US.

    But in reality...they don't care about that stuff at all..they just want to print some more money....

  • Report this Comment On January 17, 2012, at 10:24 PM, neamakri wrote:

    Employment?

    Employment comes from jobs, and the FED has no power to create jobs. Can they ask for bids to build a new railroad? Heck no!

    The FED was created by banks for banks. As such, Bernanke wrote a check for $600 Billion on MY account awhile back and gave the money to banks. PLEASE don't do this again. My grandchildren and their children already owe more than they can ever pay.

    Bernanke is university educated, by univeristies that are supported by banks.

    Just watch the movie "Too Big To Fail" for the truth.

  • Report this Comment On January 18, 2012, at 12:46 PM, ejazz2095 wrote:

    Right, because all of the quantitative easing has done us so much good so far. I think the definition of insanity is doing the same thing over and over and expecting different results.

  • Report this Comment On January 18, 2012, at 1:38 PM, DJDynamicNC wrote:

    It's difficult to argue counterfactuals, so it's not easy to say "well, it would have been worse without prior rounds of QE." There is simply no alternate universe we can point to that will explicitly make that case. People see only how bad it is, not how much worse it could have been.

    That doesn't mean it isn't true, just that it's hard to argue, since people have a much more difficult time internalizing "what could have been" versus "what is."

    Businesses hire in the face of increased demand. To enhance employment, the Fed can only work indirectly, by ensuring there is an adequate economic framework in place to generate sufficient aggregate demand. Since a lot of the decrease in demand can be directly traced to the credit crunch caused by the crisis, QE can address that credit crunch by easing up the money supply. And since refusing to take action means people will continue to suffer, it is worth pursuing QE to help stimulate that demand through easing the credit crunch.

  • Report this Comment On January 18, 2012, at 1:40 PM, DJDynamicNC wrote:

    --> "But in reality...they don't care about that stuff at all..they just want to print some more money...." <--

    Is that really the only motivation? Ben Bernanke goes to work every morning and says "Buahahaha, it's a new day, time to scheme up another way to print money as part of my nefarious plot to, uh... print... money...."

    Surely there is more motivation than that?

  • Report this Comment On January 18, 2012, at 5:48 PM, CaptainWidget wrote:

    <<Is that really the only motivation? Ben Bernanke goes to work every morning and says "Buahahaha, it's a new day, time to scheme up another way to print money as part of my nefarious plot to, uh... print... money....">>

    I think Ben Bernanke goes to work every morning thinking the same thing every useless bureaucratic thinks when they go to work.

    "I've got to convince everyone of how important I am so I can keep my job"

    His interest has nothing to do with the American people. If it did, he would admit failure when his actions harm the American consumer and reverse course to try to mitigate the damage.

    Instead he convinces them of how much worse it would have been had he not acted, how great he is when things are going well, and above all, tries to conflate every issue that crosses his desk.

    There's nothing Ben Bernanke can do to help the American people......certainly not by printing more money or buying more T-bills. If he wanted to help Americans he would start counting commodities in the price index, realize that the money supply is inflating, then raise interest rates so that people can start saving their damned money.

  • Report this Comment On January 19, 2012, at 2:57 AM, xxcrysad3000xx wrote:

    I think the case for additional QE is pretty strong, this notion that the Fed is powerless, or worse, malevolent is perplexing to me. Encouraging savings is a good thing, but increasing interest rates just raises the cost of borrowing for businesses. It also isn't clear to me why the average person with debt is going to begin saving if interest rates suddenly go up a few measly percentage points, they're much more likely to spend that money paying down the debt they're currently saddled with.

    Inflation devalues the currency, yes, but it also decreases the real value of debt held, so it tends to be bad for creditors but good for the person holding the debt. This would be good for people with underwater mortgages, and many economists agree that until real estate bounces back the recovery process will be a slow one indeed.

    I'm not saying it's a perfect solution, if you have money in the bank the real value of that money decreases as well, or if you're on a fixed income or defined benefit pensions plan. If you're an investor or someone looking for a loan, or one of millions of Americans mired in debt, its not so bad, particularly if it does have the stimulative effect on job creation that at least theoretically it should. Anything in the way of economic growth is of course a benefit to all Americans, and I don't think Ben Bernanke is acting in bad faith when he pulls on the three levers (what it looks like to us laymen) that he has at his disposal.

    And one last thing regarding inflation of currency, you know that massive outstanding debt we have looming over our heads? That bogeyman that's basically hogtied Congress their entire session? Yeah, it would bring the real cost of that down too.

  • Report this Comment On January 19, 2012, at 5:14 AM, CaptainWidget wrote:

    <<I think the case for additional QE is pretty strong, this notion that the Fed is powerless, or worse, malevolent is perplexing to me. Encouraging savings is a good thing, but increasing interest rates just raises the cost of borrowing for businesses. It also isn't clear to me why the average person with debt is going to begin saving if interest rates suddenly go up a few measly percentage points, they're much more likely to spend that money paying down the debt they're currently saddled with.>>

    The interest rate needs to go up hundreds of basis points, but in reality, anything other than "next to zero" would be an improvement. It's pretty obvious that 0% interest rates would be an almost non-existent phenomenon in a real market, so the price ceiling on the price of money is making it too cheap, pushing too much out into the market.

    <<Inflation devalues the currency, yes, but it also decreases the real value of debt held, so it tends to be bad for creditors but good for the person holding the debt. This would be good for people with underwater mortgages, and many economists agree that until real estate bounces back the recovery process will be a slow one indeed.>>

    So you're suggesting that everyone simultaneously defaulting on their debt would be good for the economy? All that evaporated value doesn't get consumed by thin air...the credit issuers have to eat those losses. Then what happens? Their share price drops (along with my 401K)? They lay off employees? They stop giving out loans? They completely go out of business, taking my money with them? This is the fallacy of "new" economics (I won't even say Keynesian, because it's pervasive). That things can happen without cost. Trust me, the cost of deflation reducing the value of debt would be catastrophic.

    <<I'm not saying it's a perfect solution, if you have money in the bank the real value of that money decreases as well, or if you're on a fixed income or defined benefit pensions plan. If you're an investor or someone looking for a loan, or one of millions of Americans mired in debt, its not so bad, particularly if it does have the stimulative effect on job creation that at least theoretically it should. Anything in the way of economic growth is of course a benefit to all Americans, and I don't think Ben Bernanke is acting in bad faith when he pulls on the three levers (what it looks like to us laymen) that he has at his disposal.>>

    It's not a perfect solution...it's the exact opposite solution that we want. Theoretical question, would you rather have US dollars be infinitely valuable or infinitely value-less? Infinite weakening creates a world where no matter how hard you worked, your money was completely worthless, or at least worthless outside of the US. Infinite strengthening would mean that a single penny that you found in your glove compartment would buy you every material desire you could ever want for the rest of your life, or at least it could buy that outside of the US.

    The notion that deflation (AKA strengthening) the US dollar is mad. There's no fear of actually running out of physical money (which is the only worry in deflation, that people are actually taking bills out of circulation, creating a situation where there's not enough physical notes to fulfill all the current balances on the books). People are able to hold the balances they desire.....easily. As long as we're not physically running out of cash (IE people go to the banks to withdraw and there simply aren't enough bills to put in their hand) then deflating is a good thing. It makes your purchasing power go up relative to other currencies. More purchasing power good.....less purchasing power bad......I can't fathom how this is such a misunderstood concept.

    <<And one last thing regarding inflation of currency, you know that massive outstanding debt we have looming over our heads? That bogeyman that's basically hogtied Congress their entire session? Yeah, it would bring the real cost of that down too.>>

    And again...at what cost? We hyper inflate our money supply so we can pay off the national debt...then what? Because we default on value (but not on monetary figures) of the outstanding debt, we become a bad credit risk. People aren't stupid......if we printed out a 15 trillion dollar bill and handed it to China they would laugh in our faces. You can't just hyper-inflate to pay down your debt and not expect consequences.

    The consequence would be...no one would ever loan to us ever again. And now we're just pumped another 15 trillion US greenbacks into the market, destroying the value of all dollars in the US and driving the price of everything through the roof. The consequences of the things you suggest are dire. Stop drinking the federal reserves kool-aid. The people who want to take value straight of your bank account without your permission are NOT your friend.....

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1759230, ~/Articles/ArticleHandler.aspx, 11/21/2014 1:22:17 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement