Strategic Quantitative Easing

Dr. Sankarshan Acharya
University of Illinois (U.S.A.)
and Research Center for Finance and Governance (India)

November 4, 2010


The Federal Reserve announced yesterday that it would buy $600 billion of longer term Treasury securities by essentially printing money, which is euphemistically called quantitative easing (QE). This is the second QE. The first QE was done in 2008.

The idea behind QE is that investors selling their Treasury securities to theFed forcash will earn .25% on their cash deposits, unless they reinvest the cash in real businesses that employ people and fetch potentially higher expected returns (than .25%) consistent with the risk of such businesses. QE can thus create new employment if investible businesses not tapped so far exist. The investors may choose to invest their cash in emerging markets overseas. Only if such overseas investments generate demands for goods made in the U.S. will it generate jobs for Americans.

QE will also lower the mortgage interest rates that may help mortgage borrowers refinance their home loans at lower rates to free up cash for spending, which may enhance business activity and employment. But refinancing is infeasible for most underwater homes with market prices less than existing mortgage loans.

There is thus no guarantee that Fed's QE will raise employment in the U.S.

This is why I had proposed to the U.S. President and Congress on October 8, 2010 for Strategic QE. I am not sure if the Fed received my proposal.

Here is an example of $1 trillion in QE that can create widespread optimism, with little inflation and a potential boost to the economy.  The net cost is just $40 billion to the government (taxpayers):

  1. The Federal Reserve purchases $1 trillion of outstanding credit card debt from financial institutions and refinances the credit card debts held by the households at 4%.
  2. The cost of money to the Fed is 0%.
  3. The financial institutions will have $1 trillion in extra money.
  4. The worst that banks can do to the economy is simply to lend the new money to government, say, at 4%.  It would cost the government 4% or $40 billion.  It will transfer to households about 8% or $80 billion from banks, if the credit card balances are at an average of 12%.  But this will spread optimism and spending by consumers, more discretely this time because of the financial ruin they have faced.
  5. The best the banks can do is to invest the money in the real economy.  Even if a part of it goes to the emerging markets, it will raise the buying power of the developing nations.  I am amazed to see how even remote corners of India are now being lined with grading machines from Rand Corporation and farm machinery from John Deere.  The increased exports to the developing countries can boost jobs at home.
  6. The banks will suffer a loss of about 8% or $80 billion, but they can recoup it from increased business here and across the globe.
  7. The net cash pumped to American households holding credit card will be $80 billion.  This will cause little inflation.

Banks are opposed to the QE-2 announced yesterday.  Many pundits too have opposed to QE-2.  Their logic is that banks are already flooded with money and need no more since the demand for loans is little. 

How will Strategic QE work: The same banks had wanted the Fed to refinance their loans at .25%.  They have prospered, at least on the surface, to pay their executives massive salaries and perquisites.  It will be silly for the bankers and pundits to complain about Strategic QE to refinance households. 

The strategic QE can achieve a remarkable goal of fulfilling the common longing of people to cut government debt: If the credit card companies - who will receive, in my proposal, the $1 trillion from the Federal Reserve for their credit card (CC) loans made to households - lend the money back to the government by buying Treasury securities, the government should use the money to cut federal debt by $1 trillion.  This is what I meant in my proposal by stating that the net money pumped to the economy will be $80 billion, which is miniscule to cause any inflation, especially when the government is cutting its outstanding debt, though through an increase in the Fed balance sheet.  So, my proposal will achieve the following important goals:

  • Transfer about $80 billion in CC interest savings to households per year.  This is like a $2 trillion dollar instant boost in CC household wealth at about 4% cost of capital according to the Gordon formula, 80B/.04 = $1000B.
  • Cost the government nothing.
  • Reduce the federal government deficit by $1 trillion.
  • Increase the Fed balance sheet by $1 trillion.

The question is whether the nonstrategic QE-2 that the Fed announced yesterday will deliver the potency of the proposed Strategic QE in averting Great Depression II. My prognosis is that the economy will need Strategic QE to refinance CC Debt and Mortgage Debt at lower rates to avert a depression.

Any form of subsidy to groups of banking or nonbanking firms or households is inefficient and unconstitutional. But the financial firms have received massive subsidies from (a) the Fed ($2.5 trillion in financing with collaterals in 2008), (b) government ($700 billion in TARP), (c) investors (decimated security holdings covering short positions), and (d) depositors (lower interest rate on deposits set by Fed fiat). This represents a massive unconstitutional subsidy from nonfinancial firms and households, who lost enormously during the Great Recession of 2008, to the financial firms and borrowing households that caused the crisis.

The proposed Strategic QE may restore some constitutional equality in subsidy created for financial firms and nonfinancial firms including households.


What the Fed did and why: supporting the recovery and sustaining price stability
By Ben S. Bernanke

Thursday, November 4, 2010

Two years have passed since the worst financial crisis since the 1930s dealt a body blow to the world economy. Working with policymakers at home and abroad, the Federal Reserve responded with strong and creative measures to help stabilize the financial system and the economy. Among the Fed's responses was a dramatic easing of monetary policy - reducing short-term interest rates nearly to zero. The Fed also purchased more than a trillion dollars' worth of Treasury securities and U.S.-backed mortgage-related securities, which helped reduce longer-term interest rates, such as those for mortgages and corporate bonds. These steps helped end the economic free fall and set the stage for a resumption of economic growth in mid-2009.

Notwithstanding the progress that has been made, when the Fed's monetary policymaking committee - the Federal Open Market Committee (FOMC) - met this week to review the economic situation, we could hardly be satisfied. The Federal Reserve's objectives - its dual mandate, set by Congress - are to promote a high level of employment and low, stable inflation. Unfortunately, the job market remains quite weak; the national unemployment rate is nearly 10 percent, a large number of people can find only part-time work, and a substantial fraction of the unemployed have been out of work six months or longer. The heavy costs of unemployment include intense strains on family finances, more foreclosures and the loss of job skills.

Today, most measures of underlying inflation are running somewhat below 2 percent, or a bit lower than the rate most Fed policymakers see as being most consistent with healthy economic growth in the long run. Although low inflation is generally good, inflation that is too low can pose risks to the economy - especially when the economy is struggling. In the most extreme case, very low inflation can morph into deflation (falling prices and wages), which can contribute to long periods of economic stagnation.
Even absent such risks, low and falling inflation indicate that the economy has considerable spare capacity, implying that there is scope for monetary policy to support further gains in employment without risking economic overheating. The FOMC decided this week that, with unemployment high and inflation very low, further support to the economy is needed. With short-term interest rates already about as low as they can go, the FOMC agreed to deliver that support by purchasing additional longer-term securities, as it did in 2008 and 2009. The FOMC intends to buy an additional $600 billion of longer-term Treasury securities by mid-2011 and will continue to reinvest repayments of principal on its holdings of securities, as it has been doing since August.

This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

While they have been used successfully in the United States and elsewhere, purchases of longer-term securities are a less familiar monetary policy tool than cutting short-term interest rates. That is one reason the FOMC has been cautious, balancing the costs and benefits before acting. We will review the purchase program regularly to ensure it is working as intended and to assess whether adjustments are needed as economic conditions change.

Although asset purchases are relatively unfamiliar as a tool of monetary policy, some concerns about this approach are overstated. Critics have, for example, worried that it will lead to excessive increases in the money supply and ultimately to significant increases in inflation.

Our earlier use of this policy approach had little effect on the amount of currency in circulation or on other broad measures of the money supply, such as bank deposits. Nor did it result in higher inflation. We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time. The Fed is committed to both parts of its dual mandate and will take all measures necessary to keep inflation low and stable.

The Federal Reserve cannot solve all the economy's problems on its own. That will take time and the combined efforts of many parties, including the central bank, Congress, the administration, regulators and the private sector. But the Federal Reserve has a particular obligation to help promote increased employment and sustain price stability. Steps taken this week should help us fulfill that obligation.

The writer is chairman of the Federal Reserve Board of Governors.