Evaluating the Success of Quantitative Easing

By James Dail (CMC ’20)

The financial crisis of 2008 altered existing orthodoxy on monetary policy and changed the dynamic of the American economy. Monetary policy used to be fairly simple. If the economy was in a recession, then the Federal Reserve would lower interest rates. This would expand access to credit and provide the nation with needed economic activity. If the economy was doing well, the Federal Reserve would raise interest rates, decreasing access to credit in order to rein in inflation. The 2008 financial crisis was so severe, however, that lowering interest rates to almost zero was not enough to mitigate the effects of the recession. This prompted the Federal Reserve to do something unprecedented: it embarked on a policy known as quantitative easing (QE). Now, with the economy near full employment and economic growth rates still not hitting Fed targets, many are debating the pros and cons of the QE policy. Has it achieved its policy goals?

QE involved the Federal Reserve primarily buying the faulty mortgage-backed securities and long-term U.S. government bonds held by major financial institutions. Since the Fed depleted some of its reserves to buy these assets, this increased the money supply and provided easier access to credit. The consensus around QE is that results have been mixed. Since the financial crisis, the stock market has boomed and corporations have done well due to lowered borrowing costs, but overall national GDP growth has been unusually slow, suggesting that quantitative easing has primarily benefitted corporations. As a consequence, the Federal Reserve has been forced to keep interest rates near zero for a lengthy time span. In spite of eight years of slow growth, the American economy is now essentially at full employment and the Federal Reserve Board of Governors has become embroiled in a debate about how to return to normalcy after an unprecedented last decade. Thus far, it has adopted a policy of gradually raising of interest rates and the reinvestment of its long-term bonds so as to not have a negative effect on the economy.

One may ask why the Federal Reserve needs to raise interest rates at all given that growth since the recession has been minimal. Wouldn’t it be better to maintain easy access to credit so that the economy can achieve higher growth rates? The danger lies in the fact that the American economy has been in a recovery for eight years. Boom cycles never last forever, and we will inevitably have another recession. The Federal Reserve is not going to be able to effectively fight off the next recession if interest rates are already low. Additionally, there is the danger of inflation which has an inverse relationship with the unemployment rate. After the rate of natural unemployment is reached, keeping interest rates too low will eventually causes an increase in the inflation rate, which only accelerates over time. Despite both of these concerns, there is unanimous consensus that interest rate increases have to be tapered to some extent. We have reached a point where the US is essentially at full employment, and if the Fed raises interest rates too quickly, then the instant cut-off to easy credit will shock the economy and slide us back into a recession.

The Fed is taking the goldilocks approach and is not leaning too far in either direction with interest rates rising only a quarter of a point every few months. This approach is not without its detractors, however. Criticisms of current policy tend to revolve around QE’s unorthodoxy. A common critique is that QE provided major corporations with easy money that they used to enrich themselves, thus worsening income inequality. It is also speculated that because the recession changed how the Fed conducted monetary policy, that the old rules no longer apply. Inflation has thus far failed to hit expected targets according to Fed models. This is used to argue that the Fed should keep interest rates low until the US starts hitting higher GDP growth rates.

Considering that the Fed’s models have failed to predict the accurate level of inflation, and that growth has been stagnant since the financial crisis, the detractors could be right in saying that there is something to be gained from keeping rates low. With that being said, the market is forward looking: if there is another recession on the horizon, the results could be disastrous for the U.S. economy if rates are low and the Fed has nothing to fight it with.

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