In one sense the Federal Open Market Committee’s decision today to move its intended Federal Funds rate down to “a target range … of 0 to 1/4 percent” was historic—never, since it began announcing the target rate in the early 1980s, has the Fed gone below 1%. But it’s also something of a nonevent: the actual Federal Funds rate has already spent the past week and a half below 0.2%, and the interest rates the Fed really wants to reduce are not those on short-term Treasury securities, but those being charged on longer-term Treasuries and on loans to states, cities, businesses and consumers.
The really historic development on this last front came in October, when the Fed began conducting monetary policy in an entirely new way. It could do so because it got permission, as part of the same bailout legislation that gave Hank Paulson $700 billion to play with, to start paying interest on the excess reserves that banks leave with the Fed. It is now that interest rate on excess reserves, which the Federal Open Market Committee (FOMC) dropped from 1% to 1/4% today, that sets the floor on interest rates within the banking system. This leaves the Fed to steer its open market operations—used for the past few decades mainly to manipulate the Federal Funds rate—toward other goals. From the FOMC statement:
As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.
This is what has come to be called quantitative easing, also known as printing money. How does that work? “The Fed, as the nation’s central bank, is the only instution that has the capacity to write unlimited checks on itself,” says long-time Fed hand Marvin Goodfriend, now a professor of economics at the Tepper School of Business at Carnegie-Mellon University. Basically, when the Fed buys something, it can create the money to pay for it out of thin air.
Current Fed chairman Ben Bernanke described this process in hypothetical terms in his famous “helicopter drop” speech in 2002. But despite all its frenzied acronymical activity since the current crisis began in August 2007 (I was at a conference last week where the New York Fed’s Til Schuermann jokingly tried to lure people up to the front few rows of seats with what he called a CSFF, or Conference Seating Funding Facility), the Fed avoided quantitative easing until recently. It would trade Treasury securities that it already owned for mortgage securities and the like, but it wouldn’t create new money to do so.
That was partly because some at the Fed were worried about goosing an already high inflation rate. With the Consumer Price Index now falling, that’s no longer an issue. What I didn’t realize until talking to Goodfriend this afternoon is that the paying-interest-on-reserves change has been a major factor too. As he put it in an admirably clear (if still tough going for the layman) 2002 paper (pdf!) that first sparked interest in the idea in Fed circles:
Open market operations would cease to support the interbank rate in the new regime. … Therefore, open market operations would be free to pursue another monetary policy objective.
When the Fed started paying interest on bank reserves in October, this “new regime” was upon us, and the folks at the Fed’s open market desk in New York could stop worrying about keeping the Federal Funds rate steady and concentrate on pumping money into the economy by whatever means possible. (If you’re having trouble wrapping your head around all this, don’t feel bad; I’ve had the interest-on-reserves change explained to me several times by current and former Fed officials and I feel like I’m only barely starting to get it.) So for the next year or so at least, the number that will really tell you how aggressive the Fed’s monetary policy is won’t be the interest rate but the size of the Fed’s balance sheet, which has already ballooned from $1.4 trillion at the beginning of October to more than $2.2 trillion as of Dec. 10.
Can this quantitative easing work? Goodfriend thinks so. “Technically and mechanically, the Fed’s power to write checks on itself has the potential to be highly stimulative,” he says. A similar approach was tried in Japan early this decade. It seemed to work, albeit less than spectacularly well, and the Fed’s efforts have been far more aggressive than the Bank of Japan’s. The Fed itself engaged in a sort of quantitative easing during World War II by buying Treasury securities of all different durations to finance the war effort. That worked out great.
The big issue, Goodfriend says, will be the exit strategy. At some point the animal spirits of businesses and consumers (and bankers) will return, and if the Fed doesn’t act quickly to retire most of those hundreds of billions of new dollars it’s been creating, the result will be inflation. But that’s tomorrow’s problem.