Market Volatility and QE2

The first thing to say about QE2 is that it is a very different operation from QE1.

After the collapse of Lehman and AIG in September 2008, the Fed more than doubled its balance sheet in a matter of weeks, inventing an alphabet soup of liquidity facilities to substitute for the collapsing wholesale money market. Then, after the immediate crisis had passed, instead of allowing repayments to shrink its balance sheet back down to pre-crisis size, the Fed reinvested those repayments in mortgage backed securities, so substituting for the collapsed shadow banking system.

QE2, by contrast, is about buying Treasury bonds, the market for which is nowhere near collapse. In war time, it is common practice for the Fed to support the price of Treasury debt by standing ready to buy at a fixed price. At the moment, however, the world seems more than willing to add to its holding of Treasury debt. The Fed is not supporting a fragile market, but rather imposing its own $600 billion demand on the existing robust market.

The second thing to say about QE2 is that it is a very different operation from standard monetary policy.

The textbooks still teach that expansionary monetary policy involves buying short-term Treasury bills to affect the short term interest rate and so, by influencing expectations about future short-term interest rates, to affect also the long term interest rate. From this standpoint, the only thing new about QE2 is the intention instead to buy longer-term Treasury bonds, and hence to affect the longer term interest rates directly.

But that is not how monetary policy actually works in practice. In pre-crisis days, the Fed set a target Fed Funds rate, and intervened as needed in the overnight repo market in order to achieve that target; Treasury bills were regularly involved as collateral for the repo loans, but were not typically purchased outright. From this standpoint, QE2 is non-standard on multiple dimensions; there is no explicit price target, and the operation is entirely about outright purchases.
What difference does it make?

The lack of an explicit price target means there is no anchor for market expectations. Exactly the opposite of war finance, the Fed has announced how much it will buy but left the price to the market. Volatility of price is the consequence, as markets are left to work out for themselves what the effect will be, even as the effect depends on what markets themselves do.

A significant unknown has to do with the outright purchase dimension. Normal expansionary monetary policy provides additional low-cost repo financing to dealers, which they are free to use to expand their security holdings—that is how monetary expansion gets into asset prices. QE2, by contrast, removes high-quality collateral from the system, and with it the low-cost financing that makes use of that collateral.

In times of uncertainty, the Fed is in effect joining everyone one else in the flight to quality, demanding $600 billion of the best securities in the system and supplying in return its own reserve liabilities that can be held only by member banks that are already stuffed full.

Perry Mehrling is author of The New Lombard Street: How the Fed Became the Dealer of the Last Resort (Princeton Press).

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