Siddharth Ramalingam states that increasing liquidity remains the key concern of the Fed as it tries to bring the US economy to a recovery. QE 2 is under way, but the economy’s unresponsive nature may make QE 2.5 and a possible QE 3 a necessity.

Minding the gap between QE2 and QE3

Ben Bernanke, the chairman of the Federal Reserve (Fed) recently announced that the Fed has no intentions of putting in place another round of quantitative easing (QE) once Quantitative Easing 2 (QE2) ends. However, a closer reading of the chairman’s statement makes it all too clear that the Fed isn’t, and cannot afford to be, unequivocal about the possibility of there not being another round of quantitative easing in the near future. All that can be said is that the Fed will not announce another round when QE2 ends. However, if the US economy further deteriorates in the coming months, the Fed will, in all likelihood, go in for another round of monetary measures that aim to inject liquidity into the economy; whether the measures will be similar to those that defined QE1 and QE2 remains to be seen.

QE1 focused primarily on adding liquidity to the banking system. The Fed purchased agency securities and mortgage-backed securities (MBS) from troubled financial institutions. As a consequence, the prices of these assets increased, and yields fell. Falling yields prompted private holders of these assets to either substitute their asset holdings or exit the market altogether. As private holdings in these assets declined, liquidity improved in the private sector. Without QE1, the US and the global economy would have recovered much slower from the melt-down of the financial system.

QE2 was significantly different from the first round of quantitative easing. The Fed aimed to bring down real long term interest rates by buying long term treasuries, thereby raising prices and reducing yields. Increased liquidity would indirectly cause inflation. Rising inflation coupled with falling interest rates were expected to encourage people to spend, thereby kick-starting the economy. Also, low interest rates coupled with the expectation that short-term interest rates would remain low were expected to weaken the value of the dollar, making US exports more competitive. As QE2 comes to an end, economists are still mixed about its impacts on the economy.

QE2.5, QE3, or something thereabouts

The US economy may have hit a soft patch. GDP growth in Q1 2011 slipped to 1.8 percent. Unemployment persists at unacceptable levels, low real interest rates have not stimulated consumer spending, and cash that has been pumped into the economy is sitting idle in bank vaults. It may not be the right time to put a lid on quantitative easing. In fact, the Fed does plan to carry on with what has been dubbed QE2.5. After the $600 billion allotted to QE2 is spent, the Fed plans to reinvest the value of maturing assets to the tune of about $300 billion to purchase treasuries, taking the effective amount spent under QE2 to about $900 billion. Will this be enough to keep the economy humming? If the economy veers towards another recession, will the Fed opt for a QE3? The answer is rather unclear at the moment. However, it is worth keeping in mind that weak growth, high unemployment, state and municipal sector problems, and the issues that caused the financial crisis, still loom large.

The federal deficit has been a topic of intense discussion over the last few months. If the debt ceiling does not fall significantly in August, the Fed might be forced to print more money to buy government debt; this will amount to an extension of what we know as QE2. Before QE2 was implemented, a significant portion of US debt was bought by foreign investors. Under QE2, the Fed became the majority buyer of debt. Once the funds under QE2 run out, QE2.5 will bankroll government debt. However, there is a chance that the $300 billion that will be available to the Fed to buy treasuries will not be enough to mop-up government debt that is left unfunded by domestic and international buyers. If that does happen, the Fed will be compelled to further buy the unfunded debt.

However, things may not get so bad. If increasing liquidity is the Fed’s main concern going forward, it is not necessary that the Fed engages in something like QE2. Liquidity can be injected into the economy if the Fed drops the interest rates it pays banks on the nearly $1 trillion banks hold as reserves with Feds. A drop in interest rates could make consumer lending more attractive to banks. The Fed could also put in place interest rate caps by announcing a preferred interest rate and then allowing market forces to take interest rates to that level. The Fed and the government could adopt several other measures to improve consumer and producer sentiment, to provide some momentum to the economy. QE3 or no QE3, liquidity will continue to be a major concern for the Fed. While QE2.5 runs its course, the Fed will utilize several measures to increase liquidity and spur growth. It need not even label its policy actions as quantitative easing!