Wednesday, May 4, 2011

A Brief History of the Fed and the Financial Crisis Part II: QE I and II

Here is Part I.

This post I'm going to talk about Quantitative Easing, which the Fed pursued with two different programs over the course of the last 2 1/2 years.

Quantitative Easing 1 (QEI):

Here are two other useful timelines that were written when the second round of quantitative easing (QEII) was expected:

Calculated Risk: A QE1 Timeline
WeeklyBasis: Quantitative Easing 101Link

Now, the model we use in class of the fed funds market predicts that once the Fed is on the flat part of the reserve demand curve (i.e. at the rate where the Fed pays interest on reserves) there is nothing left for the fed to do vis-1a-vis interest rates. If the Fed did not pay interest on reserves then the "floor" on the Fed funds rate would be at 0% because no bank will loan money at a rate lower than zero ( a negative interest rate) because then you are paying someone to borrow from you. In either case this is know as the "liquidity trap". By December of 2008 the Fed was fully "caught" in the liquidity trap.

The Fed however was not necessarily out of bullets. I'm going to repeat figure 1 from part 1:

Figure 1 (from part 1)

Again, you will notice that the fed funds rate has a very direct effect on short term rates but less of an obvious or direct effect on longer rates. Since there was clearly a problem brewing in the mortgage/housing industry the Fed set about trying to solve the problem directly. In November of 2008 the Fed announced that it would buy $600 billion in "agency backed" (top of the line?) mortgages starting in January of 2009. As the WeekBasis post above points out, before the fed bought any mortgages mortgages rates dropped by 1% in anticipation of the purchase.

Figure 2

Figure 2 shows the interest on prime mortgages. There is a very clear decline in the interest rates of mortgages. There was also a very clear decline in AAA corporate bonds and 10 year treasury bonds which are close subsitutes for mortgages (important for QEII).

It's important to understand what is going on here. The Fed is simply preforming open market purchases--which means increasing the money supply--but instead of buyin short term treasury bonds the fed is simply buying longer terms private instruments. That is to say, there is (literally) no law that says that the Fed's only focus should be on the single fed funds interest rate. Since the fed funds rate had essentially become useless as an instrument of monetary policy the Fed went directly to the source of the problem and changed mortgages rates directly. It bought down mortgages rates in an attempt to make it cheaper and easier for people to buy and/or (probably more importantly) refinance their homes.

In March the Fed announced the would purchase a total of $1.2 trillion in "agency backed" (guaranteed by Fannie and Freddie) mortgages.


The Fed had finished its mortgages purchases by March 2010. In late August Bernanke started talking about a second round of quantitative easing. In early November the Fed officially announced that it would purchase another $600 billion ($75 a month) in securities. However, QEII is slightly different that QEI. While QEI was a direct purchase of mortgages QEII is a program to purchase 10-year treasury bonds. Why? Well, the interest rate on 30-year mortgages is actually based on 10-year treasury bonds. The average mortgages is held for 10 years so fixed rate "conforming" mortgages rates are based on the 10-year treasury rate with a risk premium. That is why they track so closely to the 10-year treasury bond in figure 2.

However, it looks at least from the above graph that QEII has not had the kind of pronounced effect as QEI, at least not on mortgage rates. If anything it looks like the expectation of QEII was most of its effect. Mortgages rates went slightly lower at the end of 2010. However, the QEII effect may also be beyond an interest rate decrease. The Fed forcasting that it QEII will create 700k jobs. It is after all still increasing the money supply.

QEII is expected to end (without a commitment of more money by the Fed) in June of this year.

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