QE2 (Quantitative Easing 2): Did It Work?
QE2 is the nickname given to the Federal Reserve's second round of quantitative easing. It lasted seven months, from November 2010 to June 2011. When it was launched, the Fed announced it would buy $600 billion of Treasury bills, bonds and notes by March 2011. This maintained the Fed's portfolio of securities at its record $2 trillion level.
The Fed needed QE2 because QE1 didn't quite work as well as planned.
The Fed bought securities from banks to force them to keep rates low. Typically, this would encourage them to lend more money, increasing the money supply and boosting growth. However, the banks didn't increase lending as the Fed wanted them to. They simply held onto the extra credit, using it to write off foreclosures or just saving it in case they needed it. The banks said they couldn't find enough credit-worthy people after the recession. They didn't mention that many had raised their lending standards since 2007, hoping to avoid more bad debt.
So, the Fed adjusted. It announced it would maintain its holdings at the $2.054 trillion level. It would buy $30 billion a month in longer-term denominations, such as 10-year Treasury notes. Its goal was to keep interest rates low to make housing more affordable. It also wanted to make Treasuries unattractive, to force investors back into mortgages.
The Fed Shifted Its Focus With QE2
With QE2, the Fed was trying to spur mild inflation. Why? It wanted to stimulate the economy by increasing demand. When prices rise slowly and consistently over time, people are more likely to buy now to avoid the future price increase. In other words, the expectation of inflation is a powerful driver of demand.
The Fed's target rate of inflation is 2 percent. The Fed uses the core inflation rate, which excludes volatile gas and food prices, as its measurement tool. Gas prices usually rise each spring as investors expect increased demand from the summer driving season. Food prices soon follow since transportation costs are a big component of food costs. The Fed doesn't want to change its monetary policy in reaction to that seasonal shift. That's why the Fed uses expansionary monetary policy when it appears we already have price increases in food and gas.
Why was the Fed ignoring its primary mandate to avoid inflation? It was more concerned that the sluggish economy would create deflation. This consistent decline in prices is always a bigger threat to economic growth than inflation. The best example of how this works was in housing, which experienced a near 30% deflation in prices during the recession. Thanks to deflation, people were hesitant about buying homes until prices started trending up again. Until that happened, deflation kept homebuyers on the sidelines. This allowed housing prices to fall further.
However, many investors weren't worried about deflation. They were more afraid the Fed would overshoot its inflation target, creating hyperinflation.
For that reason, when the Fed announced QE2, investors started buying Treasury Inflation Protected Securities, or TIPS. Others started buying gold, a standard hedge against inflation. As a result, gold prices set new records.
The Fed ended QE2 in June 2011. It maintained its balance of $2 trillion in securities. Panicked gold bugs drove the price of this commodity to $1,825 an ounce. Investors would have preferred to see the Fed sell holdings or even raise interest rates. For some reason, they were more worried about inflation than the sluggish economy.
Why Announcing QE2 Was So Effective
Fed Chairman Ben Bernanke had announced QE2 before he began buying. He also announced the end of QE2 in April 2011, three months before it was over, in his first-ever press conference. In it, he announced that the Fed would stop the QE2 program at the end of June.
Bernanke had learned from the success of former Fed Chair Paul Volcker. He understood that setting the public's expectation of Fed action in advance was as important as the central bank's action itself. Volcker used this consistency to clean up the stagflation mess created by his predecessors. Their stop-go monetary policy, where interest rates rose and fell unexpectedly, confused the markets. That created an expectation of ever-higher inflation. Businesses just kept raising prices to protect themselves from the Fed's inconsistent actions. Volcker ended double-digit inflation primarily by being consistent.
Quantitative Easing Before QE2
QE2 was a creative use of an existing tool. The Fed historically used quantitative easing as part of its expansionary monetary policy. It usually held at least $700 billion of Treasury notes at any given time. The Fed used this portfolio to stimulate growth during recessions or slow it down during a bubble. However, the financial crisis of 2008 exhausted the other Fed tools. The Fed funds rate and the discount rate were already at zero, and the Fed was even paying interest on banks' reserve requirements. For more, see Current Fed Interest Rates.
By November 2008, the Fed realized it needed to step up quantitative easing. It announced the launch of what is now called QE1. This program was innovative. The Fed added massive purchases of mortgage-backed securities (around $600 billion) to its regular purchases of Treasuries. By March 2009, the Fed had more than doubled its holdings of bank debt, MBS, and Treasury notes to a record $1.75 trillion. A year later (June 2010) the Fed's holding were even higher, setting a new record of $2.1 trillion. The Fed cut back on purchases, thinking the economy was recovering. By August it reinstated QE1, buying $30 billion a month in longer-term Treasuries such as the 10-year note.