The US Federal Reserve (Fed) followed a monetary policy by purchasing $1.7 trillion worth of government and mortgage-backed securities as part of its quantitative easing (QE) to stimulate the economy. This easy monetary policy involved  using a specified quantity of money which was announced first hand. This policy was thus closed-ended in nature, and involved buying securities and not  onlyTreasury securities. Its objective was to drive the federal funds rate close to zero. It seems that effectiveness of this policy has been limited in the form of  forcing down mortgages rates and providing support to the weakened housing market.

The new QE policy or QE2, as is dubbed now, is different from the first one. It does not involve using a specified quantity of money, and is also open-ended. [1]  It is supposed to be done in installments to get all members of Federal Open Market Committee (FOMC) on the same page. The Fed can use doses of buying securities times apart, and then sit and watch the impact on the economy. The major feather of  this QE2 or "Qualitative" Easing, as is also called, is that it involves buying 10-year long term Treasury securities and not just securities as it was in the first QE. Thus, it is supposed to target the 10-year long-term interest rate and not the overnight federal funds rate. It also involves capping the long rate at a certain level by buying the T-securities. It has been called the “Bernanke put” which implies that capping the rate at a certain level will give investors insurance against price losses as long as the cap is on. Lowering the long-term interest rate may also exert further pressure on mortgage rates, and this in turn may persuade home owner to refinance and home buyers to purchase homes.

Why is qualitative easing more preferred now to quantitative easing? Some economists believe that lowering the long-term rate by a certain percentage point is four times more effective than lowering the overnight federal funds rates by the same percentage. Moreover, the Fed has already dropped the federal funds rate close to zero and the economy is now up to the zero lower bound. There is no more room for the Fed to maneuver by continuing to target the federal funds rate. Some also believe that targeting the long-run rates would nudge inflation up some, which is also desirable now as it would save the economy from bouts of deflation that take a long time to deal with. Finally, lowering the interest rate on the Treasury securities is good for the federal budget as the governmnet can sell its securities at lower cost of borrowing.

There are those who are vehemently against any QE at this time of the recovery. They see it as a response to the pressure that calls for  doing something different before the midterm congressional elections scheduled on November 2nd. They also consider QE a a source of increasing uncertainty as a results of increasingly bloated Fed's balance sheet. QE2 is also viewed as a  dollar buster that will bring in imported inflation, and will eventually lead to higher inflation and interest rates.

I have a different opinion from those two views discussed above. In liquidity trap many economic variables hardly move. Budget deficit is not inflationary, monetary policy is not effective and, the monetary base is not inflationary. This narrative should apply to yields on long term Treasury securities. It requires a substantial amount of QE to get the long-term interest rate to go down by a meager amount. Professor Hamilton of University of California at San Diego (my favorite place in the U.S.) estimated in a recent paper that it takes a purchase of $400 billion of government bond to nudge the interest rate down by a meager 13 basis points (i..e, 0.13%).The Kansas City Fed President Hoenig estimated drop in the rate to be between 10-25 basis points or 0.1% -0.25% for a purchase of $500 billion dollars of government securities.. Based on what happened in QE1, homeowners switched to lower fixed rate mortgages and did not seek cash out refinancing and use the cash to have a new kitchen or go on a dream trip. Junk bond companies replaced their  high yield debt by low interest rate debt. Healthy companies issued low yield bonds and used the proceeds to increase dividends to shareholders or acquire or merge with another company. At the end there has been no substantial increase in spending or hiring. Something we have to worry about: is a substantial part of unemployment structural? If so, the Fed's success will again be limited. The Fed's chairman said that most of unemployment is cyclical and increasing demand should take care of. But why is this not happening?

It will be interesting to see if lowering the long-run interest rates will work in a liquidity trap where the short term rates have not..