Federal Reserve Bank of St. Louis The Federal Reserve significantly increased bank reserves and the monetary base after Lehman Brothers announced on September 15, 2008, that it had filed for chapter 11 bankruptcy protection. The Fed took additional steps toward quantitative easing (QE) on March 18, 2009, when it announced that it would purchase up to $1.725 trillion in mortgage-backed securities and government and agency debt. Recent speculation that the Federal Open Market Committee (FOMC) may purchase an additional large quantity of government debt to stimulate economic growth, increase employment, and prevent deflation has prompted considerable debate over the effectiveness of additional quantitative easing (QE2). This synopsis analyzes some of the central issues in this debate. One key issue is whether additional large-scale securities purchases by the Fed would cause interest rates to decline significantly. Recently Gagnon et al.1 used several methods to investigate the effect of the FOMCâs announced securities purchases ($1.725 trillion) on the 10-year Treasury yield, which they estimate to be in the range of 38 to 82 basis points. Some might conjecture that an FOMC commitment to purchase, say, an additional $1 trillion in securities could reduce the 10-year yield by a comparable amount (22 to 48 basis points). These estimates may be too large and need to be confirmed by further research. Moreover, some commentators (e.g., Narayana Kocherlakota, president of the Minneapolis Fed2) have suggested QE2âs effect on Treasury yields may be âmutedâ because financial markets are functioning much better than they were in the spring of 2009. There is another reason that the effect on interest rates could be small. Banks are currently holding about $1 trillion in excess reserves rather than making loans and increasing the supply of credit to the non-banking segment of the credit market. It is possibleâperhaps even likelyâthat almost all of any increase in the supply of credit associated with QE2 simply would be held by banks as excess reserves. If so, the effect of QE2 on interest rates could be small and limited to an announcement effectâthe effect associated with the FOMCâs announcementâindependent of the effect of the FOMCâs actions on the credit supply. Even if QE2 did affect interest rates, many believe that the effect on output or employment would be small. http://research.stlouisfed.org/publications/es/10/ES1029.pdf
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