QE2: Fed bond purchases end, leaving mixed legacy as economic recovery lags

June 29, 2011

Thursday morning, a half-dozen or so staffers will gather in a small room on the ninth floor of the Federal Reserve Bank of New York building in Lower Manhattan. The traders will sit at computer terminals and buy $4 billion to $5 billion in U.S. Treasury bonds, using dollars newly created by the act of their clickety-clacking at their computers.

When they finish, well before lunchtime, the Fed’s much-debated effort to strengthen the U.S. economy by buying $600 billion in bonds, launched in the fall, will be over.

The effort, which became known in financial circles as the second round of quantitative easing, or QE2, was the Fed’s effort to avert a slip into another recession and toward deflation, or falling prices. As it ends, it shows more than anything the limits of the power of monetary policy to correct what ails the U.S. economy.

Economic growth is set to be somewhere around a 2 percent pace in the first half of 2011, when the QE2 bond purchases took place. That is slower than the economy’s long-term growth path and nowhere near enough to dig out of the nation’s deep economic hole.

It’s not that QE2 had no impact. Inflation was well below the Fed’s unofficial target of around 2 percent last summer, and the chance that deflation, or falling prices, might take hold seemed real. That risk is now minuscule, and inflation is roughly in line with the Fed’s target.

And the bond purchases also appeared to have their intended result of boosting financial markets. With the Fed buying vast sums of Treasury bonds, investors have had to deploy their money elsewhere, helping pump up the value of corporate bonds and the stock market. The Standard & Poor’s 500-stock index is up 25 percent since late August, just before Fed Chairman Ben S. Bernanke gave a speech raising the possibility of bond purchases.

The action also contributed to a declining value of the dollar, which makes U.S. exporters more competitive. The dollar is down 10 percent against other major currencies since that same day in August.

But the uneven job creation and weak economic growth mean that QE2 will have a mixed legacy.

“If you come at it from the point of view that you think deflation risk was significant last summer and you want to avoid that, QE2 was a success,” said Michael Gapen, senior U.S. economist at Barclays Capital. “If you look at it from the point of view that you wanted to make the recovery stronger and more durable, you would have a lingering bad taste in your mouth.”

The decision to undertake the effort — within the Fed, it is known as large-scale asset purchases, though Bernanke has used the QE2 shorthand occasionally — has come at some cost for the Fed. With nearly $3 trillion in assets on its balance sheet, it will be trickier for the central bank to eventually exit from its easy-money policies than it would have been if it had held off.

The first round of easing, announced in early 2009, appears to have had a greater impact. At that time the financial markets were in disarray, and the Fed’s purchase of more than $1 trillion in securities helped lower mortgage rates and return financial markets to normal functioning.

“The magnitude of the effect from bond purchases was biggest when you were in the middle of a panic and the announcement helps reverse the panic,” said Diane Swonk, chief economist at Mesirow Financial.

One of the major channels through which lower interest rates can help the overall economy is by making it possible for people to refinance their mortgages at lower interest rates, leaving them with more take-home pay to buy other things.

But with credit standards tightened and millions of Americans owing more on their mortgage than their homes are worth, Fed easing has less impact. Even if the Fed succeeds in getting mortgage rates lower, not as many people can refinance their mortgages, because they don’t qualify.

This time, even the impact on interest rates has been hard to discern. The rate the U.S. government must pay to borrow money for a decade — 3.1 percent on Wednesday — is higher than the 2.5 percent rate around the time of Bernanke’s August speech.

All of which points to the Fed sitting on its hands and not engaging in another round of bond purchases, or QE3, unless there again seems to be a risk of deflation.

“As of last August,” Bernanke said in a news conference last week, “inflation was too low and falling, and unemployment looked like it might be even beginning to rise. . . . I think we are in a different position today.”

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