The Federal Reserve is Not Going QEII Until After the Election

There has been a lot of speculation about what the Federal Reserve will or will not do regarding quantitative easing (QE) in order to boost the economy. With the Obama administration constrained regarding fiscal policy, attention has turned to the Fed. However, I don’t believe the Fed is likely to do anything major until after the economy has weakened further, if only for political reasons.

The thinking is that the Fed can pump some money into the economy in order to prevent the economy from weakening. In my view, this thinking misses the point. First, QE is basically an asset swap and as such does not have an impact on the real economy. Second, the Fed is a political organization which treads lightly on politicized issues like quantitative easing.

Quantitative easing doesn’t actually have an impact on the real economy. It is an asset swap whereby the Federal Reserve buys Treasury bonds and sells dollars it prints out of thin air. After the asset swap, the primary dealer which sold the Treasuries to the Fed now has cash instead of Treasuries and the Fed has Treasuries instead of the cash. While the new money can ostensibly be lent out because the transaction has created reserves, the reality is that this money will sit in a bank vault idle unless the demand for loans warrants otherwise. It is a misunderstanding of how the banking system works to assume the mere creation of reserves has any significanceregarding lending. In fact, I would argue the swap is deflationary because it drains the economy of interest-bearing assets that add to income, replacing them with non-interest bearing assets. Why would we want the Fed to print money then if we know this will just create excess reserves as it did when the Fed began credit easing last year?

Moreover, we are on the cusp of a very important mid-term election. The Republicans are likely to make significant gains in part due to voter dissatisfaction with the economy. Right now, the Fed has signalled it believes the economy is weak and is prepared to do more to bolster it, if necessary. Not that the Fed can do anything. Nonetheless, it could try. But, it would be highly unusual for the Federal Reserve to insert itself into this election by trying to ‘engineer a more robust recovery’ just as elections are being held. John Brynjolfsson of Armored Wolf made similar comments about the Fed on the eve of the FOMC statement this past week. He agrees with me that the Fed’s hands are tied until after the election (video below).

So, there is not likely to be any major stimulus – monetary or fiscal in the next two months. For those looking for stimulus, the most they should hope for is something involving the Bush tax cuts. Otherwise, the U.S. economy is on its own until after the election.