Thursday, August 30, 2012

QE3 Alternative

How can the Federal Reserve inject $1.6 trillion dollars into the economy without printing a single additional dollar? 

Banks have to store some money at the Federal Reserve as proof of funds in case there is a run on the bank. It acts as a backstop. Everything that goes above and beyond federal regulation is known as excess reserves. The Federal Reserve used to, as in it always had, paid a 0% interest rate - IOER rate - on these deposits. That changed during the financial crisis. It was a new monetary tool introduced at the worst possible time.

The intent was pure. By offering banks a positive interest rate on these reserves held at the Fed, it would add another layer of stability to the financial system. Great. Only problem is that it sucked $1.6 trillion dollars out of the economy right when the economy needed it the most. It had the unintended side effect of being quantitative tightening when the economy needed quantitative easing. Remember that QE1 and QE2 introduced a total of $2.0 trillion to the economy - only for seventy percent of that to be sucked right back out again.

By reducing the IOER rate from 0.25 down closer to 0.00 for the time being, the banks have a greater incentive to lend instead of just holding excess reserves. If inflation starts to become an issue again, then its a very easy raise the IOER rate in real time. No major announcement or policy shift needs to happen. Similarly, an open-ended bond buying program would have the same effect but that seems to be a bridge too far right now (pun) for a Fed Reserve that likes to reach consensus, instead of a simple majority, before announcing new policy.

Many other new sources and blogs are saying that Bernanke is not going to do this because there might be, could be, its possible that there would be significant disruption to certain sections of the financial economy. In other words, there is a lot of uncertainty on what the downside risk to the economy could be. If there is something that economists hate, it is uncertainty.

The best criticism of the Fed doing this is that it would not be effective as long as overall demand of the economy remains low. That is a criticism not so much of lowering the IOER rate, but of monetary policy in general. To be honest, I believe the idea is worthy of merit. If nothing else, "it's not so scary" as some make it out to be.

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