Bernanke Explains QE2: Why Bond Buys Will Work and Won't Spark Inflation

Bernanke Explains QE2: How Quantitative Easing Will Work Without Sparking Inflation
Bernanke Explains QE2: How Quantitative Easing Will Work Without Sparking Inflation

A day after the the Federal Reserve announced a second round of quantitative easing measures to stimulate the economy, Fed Chairman Ben Bernanke defended the the move in an op-ed in The Washington Post. Responding to criticism of the move, Bernanke said the stimulus will not spark inflation.

The Fed's dual mandate is "to promote a high level of employment and low, stable inflation," Bernanke writes. Today, inflation is at 2%, below the Fed's target rate. While low inflation is usually good thing, if inflation gets too low, it can morph into deflation and consequently economic stagnation, Bernanke explained. Meanwhile, unemployment is at 9.6% and the economy grew at a meager 2% rate last quarter.

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"The FOMC decided this week that, with unemployment high and inflation very low, further support to the economy is needed," Bernanke wrote. So the Fed responded with an aggressive -- and highly anticipated -- move. With short-term rates already low, "The FOMC intends to buy an additional $600 billion of longer-term Treasury securities by mid-2011."

The idea behind this approach is that it pours more money into the banking system, which leads to lower interest rates, which will boost the kind of investment that can in turn start lowering unemployment. "Easier financial conditions will promote economic growth," Bernanke says. Lower mortgage rates will boost housing; lower bond rates will encourage investment; and higher stock prices will boost consumer wealth, which will increase spending and eventually profits to economic growth, Bernanke explains.

Bernanke acknowledges that purchases of longer-term securities and asset purchases are less familiar monetary policy tools than the Fed's usual method of raising and lowering its benchmark lending rates. "That is one reason the FOMC has been cautious," Bernanke says, promising to "review the purchase program regularly to ensure it is working as intended and to assess whether adjustments are needed as economic conditions change."

"Critics have, for example, worried that it will lead to excessive increases in the money supply and ultimately to significant increases in inflation," he adds. But previous similar moves did not result in higher inflation and, he notes: "We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time."