Quantitative Easing

Matt Taibbi posted an interesting article about the upcoming round of Quantitative Easing (QE2). It is obviously true that the Fed signals their actions to the market participants.

I think that QE2 is absolutely required at this point. There has not been enough fiscal stimulus in the economy. I agree with Paul Krugman’s assessment that the expansion of government spending is a myth. The burden falls on monetary policy.

The previous round of QE probably was not enough. The banks are currently in the process of de-leveraging and solidifying their balance sheets. Even if the low reserve requirements were lowered, the most likely scenario is that the additional money would be held on the balance sheet and not loaned out. It is most likely that the stimulus effects of the previous round of QE were dampened due to this de-leveraging. In other words, as more money flowed into the banking system, banks used the money to build up their balance sheets rather than making loans. This type of easing would have worked before the crisis, since the banks would have immediately taken the cash and loaned it out.

Tthe Fed is now also purchases Asset-Backed Securities (ABS) in addition to Treasuries. In theory, this enhances the effect of QE, since this takes troubled securities out of the market and puts them on the Fed’s balance sheet. The Fed has a much longer horizon than the banks, so it is possible that they may end up making a profit from these issues. However, as Taibbi points out, QE can buoy the ABS market since the demand will be higher. However, I think that just the expectation of QE has the same effect. Unlike Taibbi, I’m not sure if this is such a bad thing.

The Fed released their minutes today, and the street seems to think that QE2 is on the horizon.