Bernanke Explains Pros and Cons of Quantitative Easing (aka Mortgage & Treasury bond buying)

Fed chairman Ben Bernanke gave a speech this morning entitled Monetary Policy Objectives & Tools In A Low Inflation Environment (full text). Markets take it as the latest confirmation that the Fed will engage in more quantitative easing—buying Treasury and mortgage bonds to lower rates—with an official announcement to confirm this as soon as their scheduled FOMC meeting on November 3.

But as we explained last week in our post entitled Quantitative Easing 101 – Rate Timeline Crisis Peak to Present, rates have already traded down in anticipation of more quantitative easing, and the actual announcement is very unlikely to bring rates down further. As for further QE education beyond our QE 101 post, the excerpt below of Bernanke’s speech today is a useful primer on how the Fed evaluates what they should do, we’ve added italicized items in brackets for clarification.

Given the [Fed’s] objectives, there would appear–all else being equal–to be a case for further [quantitative easing] action. However, as I indicated earlier, one of the implications of a low-inflation environment is that policy is more likely to be constrained by the fact that nominal interest rates [rates before adjusted for inflation] cannot be reduced below zero. Indeed, the Federal Reserve reduced its target for the federal funds rate to a range of 0 to 25 basis points almost two years ago, in December 2008. Further policy accommodation is certainly possible even with the overnight interest rate at zero, but nonconventional policies [like quantitative easing] have costs and limitations that must be taken into account in judging whether and how aggressively they should be used.

For example, a means of providing additional monetary stimulus, if warranted, would be to [engage in quantitative easing, also known as Treasury and mortgage bond buying] expand the Federal Reserve’s holdings of longer-term securities. Empirical evidence suggests that our previous program of securities purchases was successful in bringing down longer-term interest rates and thereby supporting the economic recovery. A similar program conducted by the Bank of England also appears to have had benefits.

However, possible costs must be weighed against the potential benefits of nonconventional policies. One disadvantage of asset purchases relative to conventional monetary policy is that we have much less experience in judging the economic effects of this policy instrument, which makes it challenging to determine the appropriate quantity and pace of purchases and to communicate this policy response to the public. These factors have dictated that the FOMC proceed with some caution in deciding whether to engage in further purchases of longer-term securities [aka quantitative easing].

Another concern associated with additional securities purchases is that substantial further expansion of the balance sheet could reduce public confidence in the Fed’s ability to execute a smooth exit from its accommodative policies at the appropriate time. Even if unjustified, such a reduction in confidence might lead to an undesired increase in inflation expectations, to a level above the Committee’s inflation objective. To address such concerns and to ensure that it can withdraw monetary accommodation smoothly at the appropriate time, the Federal Reserve has developed an array of new tools. With these tools in hand, I am confident that the FOMC will be able to tighten monetary conditions when warranted, even if the balance sheet remains considerably larger than normal at that time.

Central bank communication provides additional means of increasing the degree of policy accommodation when short-term nominal interest rates are near zero. For example, FOMC postmeeting statements have included forward policy guidance since December 2008, and the most recent statements have reflected the FOMC’s anticipation that exceptionally low levels of the federal funds rate are likely to be warranted “for an extended period,” contingent on economic conditions. A step the Committee could consider, if conditions called for it, would be to modify the language of the statement in some way that indicates that the Committee expects to keep the target for the federal funds rate low for longer than markets expect. Such a change would presumably lower longer-term rates by an amount related to the revision in policy expectations. A potential drawback of using the FOMC’s statement in this way is that, at least without a more comprehensive framework in place, it may be difficult to convey the Committee’s policy intentions with sufficient precision and conditionality. The Committee will continue to actively review its communications strategy with the goal of providing as much clarity as possible about its outlook, policy objectives, and policy strategies.