The Case for Quantitative Easing

It seems likely that the Federal Reserve will initiate another round of bond buying, known as quantitative easing. The move will be controversial. Monetary hawks will accuse the bank of debasing the currency; presidential candidate Rick Perry even stated that doing so would be tantamount to treason. And monetary doves will lament the bank's restraint for not doing more, regardless of how much it does or does not do.

Here at The Motley Fool, we like to have a thorough understanding of issues and their consequences before drawing conclusions. What follows, in turn, is a look behind the scenes at the Fed. I'm seeking to answer what the Fed does, how it does it, and why it may be inclined to step back into the fray by printing even more money.

A primer on the Federal Reserve
Congress founded the Federal Reserve in the aftermath of the Panic of 1907 -- a financial meltdown not unlike the one we experienced in 2008. At the time, massive amounts of United Copper Co. stock had been purchased on margin by a speculator trying to corner the market in the company's stock. When his bid failed, banks that had lent him money suffered runs that later spread throughout the country. In the absence of a central bank to add liquidity to the system, the panic didn't stop until the New York Stock Exchange had fallen almost 50% in value, numerous businesses and banks had failed, and at least one high-profile corporate emergency takeover had been approved by President Theodore Roosevelt -- I told you it wasn't unlike our recent experience!

The Fed's mandate from Congress is to promote maximum employment and stable prices -- commonly referred to as the "dual mandate." As you may expect given the gravity of these goals and the fact that Washington is involved, there's much debate about what these mandates mean. In terms of unemployment, while a consensus appears to have coalesced around a long-term rate of 5%, some economists suggest that it may have risen by 1.7% in recent years. In terms of inflation, on the other hand, while the bank seems comfortable with the present inflation rate of 3.4%, it claims to be committed to keeping long-term inflation at less than 2%.

The Fed uses "three tools of monetary policy" in pursuit of these goals -- the discount rate, reserve requirements, and open market operations. The discount rate is the interest rate charged to banks and other depository institutions on loans they receive from the Fed's lending facility, otherwise known as the discount window. Reserve requirements are the amount of funds a depository institution must hold in reserve against specified deposit liabilities like check accounts, savings accounts, and certificates of deposits. And open market operations, the Fed's primary tool for implementing monetary policy, consist of purchases and sales of U.S. Treasury and federal agency securities on the secondary bond market.

As a general rule, the Fed uses these tools in a countercyclical manner -- driving interest rates up in good times and down in bad times. A textbook example of this occurred in the late 1970s and early 1980s when the Fed increased short-term interest rates to nearly 20% to stymie the double-digit inflation raging at the time. Alternatively, following the attacks on Sept. 11, 2001, and the bursting of the Internet bubble, the Fed drove these same interest rates down to less than 1%. In both cases, the central bank was said to be "leaning against the wind" in its efforts to moderate the cyclical nature of the economy.

Response to the crisis
It isn't an exaggeration to say that the central bank's actions since 2008 are unparalleled in both size and significance. Working with then-Treasury Secretary Hank Paulson and his department, the Fed orchestrated a massive bailout of the financial sector. It opened its discount window to institutions as varied as American International Group (NYS: AIG) , General Electric, and McDonald's. It injected hundreds of billions of dollars of capital and loans into the nation's biggest banks including Bank of America (NYS: BAC) , JPMorgan Chase (NYS: JPM) , Wells Fargo (NYS: WFC) and Citigroup (NYS: C) . It helped orchestrate the acquisitions of Bear Stearns (by JPMorgan) and Merrill Lynch (by B of A) over a couple of adrenaline-fueled weekends. And it bought more than $2 trillion worth of government and mortgage bonds on the secondary market. Add up the guarantees and lending limits, and the Fed had committed $7.77 trillion to the cause as of March 2009, more than half the value of everything produced in the United States that year.

Yet the economy continues to merely limp along. According to the Case-Shiller index, nationwide housing values remain 30% off their 2006 levels. In places like Las Vegas, they're less than half. Robert Shiller even told Fool writer Morgan Housel recently that he wouldn't be surprised if home prices continue to fall for several more decades! And things look similarly grim on the jobs front. Despite a positive report earlier this month, the unemployment rate is 8.5%, and that doesn't count the millions of people who have quit looking for work altogether. With the latter factored in, the rate is probably closer to 16%, some estimates even have it has high as 22%. Though perhaps most telling of all, is the average length of unemployment. In previous recessions, the average duration of unemployment topped out at 20 weeks. It's at 40 weeks as I write!

To ease or not to ease
When you consider that maintaining maximum employment is one of the Fed's mandates, it's no surprise that the central bank is contemplating additional action. Even at the Fed, however, there remain detractors. Namely, those who are worried that additional stimulus will trigger an uncontrollable inflationary spiral akin to the Paul Volcker era. This includes Federal Reserve Bank of Philadelphia President Charles Plosser, who argues that any move to allow inflation to accelerate, regardless of the motivation, is wrong-headed. And Federal Reserve Bank of Minneapolis President Narayana Kocherlakota, who noted that the trade-off between price pressures and long-term unemployment "might well cost us too much" if further easing were put into place.

At the end of the day, however, what these so-called hawks believe is probably irrelevant. With the rotation of the Fed's monetary policy committee set to take place at its next meeting, Fed Chairman Ben Bernanke will have a far more receptive audience to the idea of further quantitative easing. And I strongly suspect, as do others, that he will take full advantage of the situation given his opinion that the Fed's failure to do so was at least partially responsible for the depth and duration of the Great Depression.

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At the time thisarticle was published Fool contributing writer John Maxfield owns shares of Bank of America. The Motley Fool owns shares of Wells Fargo, JPMorgan Chase, Citigroup, and Bank of America. The Fool owns shares of and has created a covered strangle position on Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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