There are three channels through which quantitative easing--QE--could boost the economy right now:
By taking duration risk onto its own balance sheet and thus onto the taxpayers' books, the Federal Reserve takes duration risk off of the private investor community's books. The private investor community's required rate of return on marginal risky securities thus falls, interest rate spreads fall, real interest rates charged to businesses fall, and aggregate demand increases.
By expanding the money supply now, the Federal Reserve raises rational expectations of future money supplies because it would be in some way embarrassing or costly for the Federal Reserve to fully undo its QE transactions in the future. A higher money supply in the future means a higher price level in the future, and so means higher expected inflation. With interest rates at the ZLB, higher expected inflation means lower real interest rates, and higher aggregate demand.
By engaging in quantitative easing, the Federal Reserve induces low-information investors to fear future inflation even though the Federal Reserve fully intends to undo its QE transactions in the future before the economy exits from the ZLB and thus does not intend to raise the path of the price level. These low-information investors then seek some form of protection against inflation. This raises aggregate demand.
Since the costs of undoing QE transactions are infinitesimal, and since the amount of risk taken onto the Federal Reserve's balance sheet by QE transactions are small, if QE is to give a significant boost to the economy it must be through channel (3).
Thus everyone who writes on Zerohedge that:
the fed manipulates our very life blood, as ordered by the lizard men, in order to create infinite debt and establish a soviet central planning regime...
is a public benefactor.
Paul Krugman:
What We Talk About When We Talk About QE: Karl Smith is bemused; in two posts he asks what Wall Street thinks quantitative easing does, and apparently is getting a lot of vehemence but no coherence. (I liked this comment:
Zerohedge commentary suggests the fed manipulates our very life blood, as ordered by the lizard men, in order to create infinite debt and establish a soviet central planning regime.
)
I can’t help him here. It might, however, be helpful to have a picture of what we’re talking about here. The Cleveland Fed has a nice, continually updated chart on the Fed’s balance sheet. Here’s the story up to now:
There was a period when the Fed was lending a lot of money to banks under the TALF… but most of that has been repaid. These days, QE is basically purchases of long-term federal debt and bonds issued by Fannie and Freddie, which is effectively also federal debt. And these purchases have vast effects on the economy because… well, I share Karl Smith’s bemusement.
PS: Reading a few comments, I think it’s really important to emphasize that the Fed is only buying agency mortgage-backed securities — that is, the stuff that already has an implicit Federal guarantee. A lot of readers seem to think that the Fed is buying subprime MBS or something like that, handing over money for worthless paper. Not so.
