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The Federal Reserve and risk of QE3

By Tarron Khemraj · Bankrate.com
Thursday, August 25, 2011
Posted: 1 pm ET

During QE1 and QE2 -- the first and second rounds of quantitative easing -- the Federal Reserve made large-scale purchases of various securities ranging from housing agency debt (of Fannie Mae, Freddie Mac and Sallie Mae) and mortgage-backed securities, or MBS, to longer-term government bonds. The purchase of these assets was meant to create liquidity for assets that private investors shunned -- hence, they were called toxic assets.

Market participants are once again anticipating and clamoring for a third round of quantitative easing, or QE3. Indeed, one estimate has it that markets have priced in $500 billion of new Fed purchases of government bonds. This is likely to keep bond yields low for the near future. When the Federal Reserve buys these securities it credits reserves to the banks, thus generating excess reserves which now stand at just over $1.6 trillion as of the end of July.

The money -- excess reserves -- injected into the economy by the Federal Reserve must show up somewhere in the monetary system. They become deposits as financial traders make profits from trading securities and commodities.

The weak demand for loans also has caused the unprecedented accumulation of reserves. Therefore, we have the situation where deposits are growing and loans continue to stagnate.

Unintended consequences

Several commentators continue to worry about the unintended consequences of quantitative easing. In particular, they wonder if inflationĀ could emerge if banks start lending out reserves.

The Fed pays interest on excess reserves, and it can easily push that rate to a level close to the prime lending rate so as to discourage lending to stem inflationary pressures. Therefore, we can rule out the demand-pull inflation from a rapid increase of loan demand. The scenario of demand-pull inflation is also unlikely because of the debt overhang facing American households who are still repaying years of debt made possible by easy lending standards and subprime securitization.

The poor job market recovery is also a factor creating the weak demand for loans.

Finally, banks are unlikely to lend when the prime lending rate is this low as it does not allow them to cover the risk-adjusted marginal cost of making new loans.

If demand for loans continues to be weak and banks do not want to lend at very low interest rates, then how might inflation result? One possible scenario has to do with the integration of markets and banks. To the extent the excess reserves find their way into proprietary commodity trading, that will help to push up the price of raw materials that are used to manufacture products around the world. The result will be the situation of cost-push inflation (stagflation), which will not stimulate output and job creation as the original intention to stimulate demand-pull inflation and the concomitant expansion of aggregate output.

Tarron Khemraj is the William G. and Marie Selby Chair and Assistant Professor of Economics at New College of Florida in Sarasota, Fla.

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