The Fed has already begun its third easing campaign

This article explains why quantitative easing had become the monetary tool of choice for the Federal Reserve and what kind of easing the Fed is now employing. Because the Fed feels constrained politically, it is unlikely to repeat ‘quantitative’ easing and will now ease through other means. Its most recent easing has already begun.

Traditional Monetary Policy Explained

Traditionally, monetary policy in the United States has focused on interest rates. If the economy is struggling, the Federal Reserve will lower its target rate, the Fed Funds rate, in order to stimulate economic activity.

For example, Bruce Bartlett, a Reagan-era policy advisor, tells us this was a major plank of the economic policy when the United States fought an economic crisis as Ronald Reagan came to office:

In 1979, the Fed began targeting the money supply, which brought on a recession in 1980. But inflation only fell to 12.5 percent. Continued tight money led to another recession in 1981 and 1982, which brought inflation down to 8.9 percent in 1981 and 3.8 percent in both 1982 and 1983. Ironically, this much more rapid improvement in inflation contributed heavily to the budgetary cost of the Reagan tax cut. Since taxes are assessed on nominal incomes and tax indexing didn’t start until 1985, the sharp fall of inflation shrank the tax base and increased the tax cut’s revenue loss.

The collapse of inflation also meant that real interest rates were extremely high. In early 1982, the federal funds rate was more than 14 percent, leaving a great deal of room for easing monetary policy. By the end of 1982, the fed funds rate was down to 9 percent. Thus the economic expansion of the 1980s was powered by a combination of tax cuts, falling inflation and lower interest rates.

Why the Reagan Tax Cut Worked in 1981 and Why It Wouldn’t Work Today

The Advent of Unconventional Policy

The Fed Funds rate is effectively zero percent. So, cutting interest rates has not been an option available for Fed policy since 2008. Therefore, the Federal Reserve has turned to quantitative easing in order to provide monetary stimulus. In June, I explained the differences between QE1, QE2 and a potential QE3.

the first round of large scale asset purchases by the Federal Reserve was intended to support economic activity. However, because the Fed focused on the asset side in increasing its balance sheet by buying assets it had not previously purchased in large quantities, the Federal Reserve worked to support the functioning of credit markets by providing liquidity to the private sector. Without this easing, the US and the global economy would have had a depression of indescribable severity with unknown attendant geopolitical and military consequences.

Was QE1 a bailout? Yes. But QE1 was also a legitimate lender of last resort operation. We should question the terms of QE1 i.e. "The Fed lent freely, but at a low rate, on dodgy collateral" not the operation per se.


The second round of quantitative easing was distinct from the first – and more akin to what the Japanese had done. The aim was to support economic activity in the US domestic economy. Starting in August 2010, the Federal Reserve started reinvesting principal payments from agency debt and agency mortgage-backed securities that it had acquired in QE1 in longer-term Treasury securities. By November 2010, after the 2010 mid-term elections, the FOMC decided to expand its balance sheet by $600 billion through the purchase of Treasury securities.

This is unconventional monetary policy. Each time the Fed has conducted one of these campaigns of non-traditional stimulus, there has been a vocal political opposition to it. As a result, the Fed feels constrained. As I explained last year before QE2 was officially announced,

“The Fed has already spent its political capital. And if you want a reason why the Fed isn’t doing anything about the renewed economic weakness despite Bernanke’s famous 2002 helicopter speech, this is it. The Fed knows darn well it has spent its political capital.”

So what can the Fed do? What will it do? Well, in 2010, as the economy weakened, the Fed turned to QE2. That policy ended in June. At that time I said “I am with Richard Koo. Monetary policy reflation will not work in a balance sheet recession when fiscal policy is contractionary. But at some point, the Fed will be compelled to act anyway.

Last month, I said

the Fed will pause to assess the economy before doing anything else. If economic growth in the U.S. does not falter in the second half of 2011, the Fed will look to drain excess reserves from the system as preparation for an interest rate hike at some unforeseeable future date.

There is immense pressure on the Fed from within as well as politically to refrain from more unconventional policy.The economy will weaken significantly before the Fed moves against it – and only then because of vocal outcries for more policy stimulus.

The third round of unconventional stimulus is now starting

Since then, the economy has weakened considerably. The Fed even said so directly – “economic growth so far this year has been considerably slower than the Committee had expected”. So now the QE3 speculation has begun.

Here’s what I think is happening at the Fed. Fed doves have wanted some sort of easing. Under consideration are targeting long-maturity asset purchases, setting an interest rate target or even eventually buying municipal bonds (see What QE3 could look like from June).

Fed hawks want no part of this. Look at the three dissents at the last meeting and Kocherlakota’s statement on dissenting the Fed’s permanent zero policy. So the doves have been forced to alter QE3. Here’s how I put it last month:

The Fed is likely to soft peddle this policy change because of comments from people like former Atlanta Fed President William Ford questioning Can the Fed Go Bankrupt? The Fed will want to stay to the shorter end so as not to risk its balance sheet by moving out the curve with interest rate caps. However, there could be internal dissent, so the Fed could start off by signalling to the market that it will conduct what I have been calling ‘permanent zero’. Eventually people will be forced to accept this – and the term structure will flatten further and further out the curve. That’s how Japan got to a 1% 10-year yield because expectations of zero rate policy continued to lengthen in time.

Gross and Rosenberg: QE3 will see interest rate caps

This is what we just got last week, permanent zero. I believe this is the first salvo in a renewed easing campaign by the Fed. I had been saying full-blown QE3 wouldn’t begin until 2012. In fact, the permanence of the zero to which the Fed has committed is much longer than I had anticipated. I would go so far as to call this full-blown rate easing, one of the three easing policies I identified earlier as QE3 contenders. That’s why you got three dissents at the last FOMC meeting, which you will almost never see at the Fed.

The 0.375% US Treasury note maturing on 31 July 2013 is now yielding only 19 basis points. Call this financial repression, call it rate easing, call it permanent zero or whatever you want; What the Fed has just done is effectively guarantee interest rates out to two years. In essence, QE3 has already started – and that’s bullish for fixed income investors because it guarantees a floor for non-credit-related fixed income investment risk. Interest-rate risk is gone for investments up to two years; Private equity and leveraged finance will need to get busy.

Watch the upcoming speeches at Jackson Hole to see how much further the Fed is willing to go.

  1. Dave Holden says

    “In essence, QE3 has already started – and that’s bullish for fixed income investors because it guarantees a floor for non-credit-related fixed income investment risk. Interest-rate risk is gone for investments up to two years; Private equity and leveraged finance will need to get busy.”

    OK so this is probably already in layman’s terms but could you put this into lay-layman’s terms because I don’t understand why this is bullish for fixed incoming investors.

    1. Edward Harrison says

      The Fed is basically saying to fixed income investors that there is little to no risk that we will raise rates anytime in the next two years. When thinking about your risks in investing like default risk and interest rate risk, this is significant. Now investors can confidently invest based on default risk knowing that there is almost no interest rate risk. That is bullish for bonds.

      1. Dave Holden says

        Ah OK, thanks.

  2. Hondo says

    First, I don’t believe fixed income investors will in the end think they have been dine any favors. Lower interest rates and a lit if time will help..higher stock prices are irrelevant (although refinancing with lower rates creates it’s own set of problems). Using FED liquidity is fine as long as it is used in conjunction with the necessary restructuring of debt. That means allowing banks (including equity wipe outs and debt haircuts) to go bankrupt, companies to go bankrupt. There would be much capital come in at that point to take over the clean organization. Without these action we are Japan no matter what the central bank does (which in most cases only make things worse)

  3. steve from virginia says

    Maybe the bull market will disappear but if not … methinks the Fed may be buying longer EU issues by way of primary dealers/ECB straw men.

    This may be wrong, time will tell. If the bull takes flight as per last summer, the probability is some euro-QE courtesy of Mr. Bernanke.

    If ‘downgrade-itis’ ripples through the EU and some banks fail, etc. no QE.

    Dollar QE? Hard to promote when Brent crude is @ $105/barrel. Last summer ’twas $70. $4+ gas would make QE counterproductive.

  4. PBlacque says

    OK thanks for going through the plumbing… but how will that impact the real economy? How will this put people back to work and create the agg demand required for lift off? A bull market for fixed income investors and capex (at the margin)… but if there is no Demand, there will be no Capex, no hiring, no higher income, no spending… etc.

    Can you elaborate on how you see a bull mkt for fixed income investors play out in the real world?

    1. Edward Harrison says

      I have a hard time with that one. The reason I didn’t talk about the real economy is because I don’t think QE has direct real economy effects. Perhaps this is my bias as others suggest it does. But it seems to me that the Federal Reserve mainly works through the interest income, lending and portfolio preference channels.

      Rates are already at zero percent. So the Fed can only lower longer-term rates here and that has a positive effect on mortgage rates giving relief t borrowers. But its not some magic elixir which will eliminate the negative equity across the housing sector.

      In my view, QE is small beer – except for fixed income and leveraged investors. I’m sure that Bernanke and co will tell you they are helping to increase demand and put people back to work. I just don’t see it.

      1. James says

        Not only do I agree with Edwards point but I think that fed action actually harms the economy in the long run. While the fed and other monetarists think that QE helps the real economy, the only thing that actually happens is that it inflates asset bubbles. In the short run the wealth effect causes a reduction in private sector savings rates providing a short term boost to consumption in the long run it creates suboptimal allocations of both human and financial capital which produces a large drag on economic activity

      2. David Lazarus says

        I do not see QE working on the real economy. All it has done is inflate asset and commodity bubbles which might have benefited commodity producers but few others.

  5. flow5 says

    “Bruce Bartlett, a Reagan-era policy advisor – In 1979, the Fed began targeting the money supply”

    Complete bullshit. Volcker expanded the money supply at a 20% annual rate of change after the introduction of the DIDMCA. Volcker NEVER tightened monetary policy. High interest rates are not evidence of tight money, they are evidence of an extremely easy money policy.

  6. haris07 says


    Fed fund futures were already pricing in ZIRP till end of 2012 before the Fed announcement and the 10 year had already collapsed in yield. I really am at a losst to understand why holding rates at zero till mid 2013 (approx 6 months longer than what was already priced in) and another 10 or 15bps down in yield on the 10 year is really going to do in an economy where “demand for credit” is non-existent and is not the reason for the weak economic performance at all? Same question, why woudl the Fed buying another gazillion of longer term Treasuries or even guaranteeing a 1.5% ceiling on the 10 year (or any such policy) will affect the economy (other than increase speculation for short term, influence the wealth effect and other such transitory effects)? What am I missing?

    1. Edward Harrison says


      I don’t think you’re missing anything. You know where I stand here. I think QE is bad policy. Rate targeting is more effective but still a form of financial repression which leads to malinvestment.

      Your point about demand for money is spot on here because this is a demand side problem and the fed mainly has supply side tools. I see fiscal as more demand-side oriented and monetary as supply-side.

      Also note that permanent zero is toxic for bank interest margins and leads to further zonbification. This is something I plan to reiterate in a coming post.

      I will try and ping David Beckworth who supports the monetarist view of QE to explain where the transmission mechanism resides. As much as I don’t see it, it’s good to examine the issues without ideological blinders.

      1. haris07 says

        Thanks Ed. I do know where you are (and it so happens that I am exactly where you are on these). Still, I like checking in to see if anything has changed to warrant a re-evaluation. Happy to read about what David Beckworth has to say.

        PS. I am totally on board with banks becoming even more zombies with the collapse of the yield curve. It could be instructive however to see how Japanese banks survived this (and continue to survive this). I know they became bigger, but haven’t done the exhaustive research. In any case, coupled with increasing legal liabilities (from the public sector AG’s and private sector like AIG), banks are in big trouble. As you know, the 2nd lien/HELOC book alone at these banks, if marked properly, would result in all of them going insolvent! Chris Whalen has argued that it may be better to use Dodd Frank to restructure BAC, of course it would, but the resulting panic among equity and bond investors of JPM, C and WFC will likely put the kibbosh on that (as much as I would like to get it done with and clean up the debt, stock market and bonds be damned for a short period, just protect the depositors!).

      2. David Lazarus says

        Actually zero is toxic for the public. This basically steals their income. The banks have raised their margins considerably. Why do you think that they have raised credit card rates. Lend at up to 30% and cost of funds at zero means they have huge margins as long as their customers continue to pay. There is no demand for loans because the banks have substantially increased their margins. This is the way that the Fed is helping the banks re-capitalise.

  7. Panayotis Economopoulos says

    The post on my wall on MP will help! A summary of a larger and more math paper but still readable!

  8. Panayotis Economopoulos says

    As the target gets further out interest rate policy expectations become less solid and other factors come into play complicating any control!

    1. Edward Harrison says

      Panayotis, this is true. My sentiments exactly. As I wrote in my last post “Clearly though, interest rate policy expectations become more variable as the term structure lengthens and other factors come into play”. Nevertheless, Japan shows us that rates will adjust down over time if the Fed stays at zero.

  9. Panayotis Economopoulos says

    Here, the Japanese example is showing the other factors! It is also true that the longer the experience with lower ST rates the lower the probability of policy “default” altuogh it is also true that at a given time a LT anticipation has a higher probability that this policy regime will switch!

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