As the economy began to falter amid the financial crisis in the fall of 2007, the Federal Reserve responded in the usual fashion by lowering its short-term interest rate target. But by the end of 2008, with short-term rates down to virtually zero and the economy and financial system still in trouble, the Federal Reserve adopted an unorthodox program known as quantitative easing (QE) that sought to directly lower long-term interest rates and thus stimulate the economy. To carry out QE, the Fed embarked on three rounds of purchases of long-term securities that increased its balance sheet more than fourfold, to about $4.5 trillion in 2015. As we will see, economic theory tells us that long-term rates are mainly determined by what investors expect short-term rates to be in the future. So why did policymakers think they had a shot at lowering long-term rates when short-term rates were already as low as they could go? As former Fed Chairman Ben Bernanke quipped in 2012, “Well, the problem with QE is it works in practice, but it doesn’t work in theory.” So what is the theoretical reasoning behind QE? Did QE lower long-term yields? Did it actually stimulate the economy? And what does the evidence so far say about the costs of the Fed’s unprecedented accumulation of assets?
This article appeared in the First Quarter 2016 edition of Economic Insights. Download and read the full issue.View the Full Article