New York Fed 101: The Federal Reserve’s Asset Purchases (Called by some QE or QE2)


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New York Fed 101: The Federal Reserve's $600 Billion Treasury Purchase Program (Called by some QE or QE2)

On November 3, 2010, the Federal Reserve announced plans to purchase $600 billion in longer-term U.S. government debt from the private sector. The goal of this program was to support the economic recovery, spur job creation, and ensure that inflation, over time, is at levels consistent with the Federal Reserve's mandate.

The Fed has been mandated by law to promote maximum employment and price stability. The recent recession and slow recovery through late 2010 resulted in an unacceptably high unemployment rate and an inflation rate below the level (near 2 percent¹) the Fed judges to be consistent with its mandate. It is the Fed's job to do what it can responsibly do to help bring down unemployment to the lowest level the economy can sustain over the medium term and to make sure that inflation returns to a level more consistent with its mandate.

Normally, when the economy is weak, unemployment is too high and inflation too low, the Federal Reserve lowers short-term interest rates. Lowering short-term interest rates in turn eases what economists call broader financial conditions—reducing the cost of longer-term finance and raising the value of assets such as stocks and homes. Lower interest rates in the United States typically results in some downward pressure on the foreign exchange value of the dollar as well. All these factors support spending, employment and growth.

But in late 2010 there was little scope to lower short-term rates further because these rates were already near zero. So the Federal Reserve decided to use large-scale purchases of longer-term assets as a means to ease financial conditions and support economic activity instead. Asset purchases had already been used successfully in recent years, and in August 2010 the Fed began reinvesting repayments of principal on the securities it had already purchased. The Treasury securities bought under the asset purchase program are backed by the full faith and credit of the U.S. government.

Like lowering short-term interest rates, buying assets eases financial conditions through several channels. Such purchases put downward pressure on longer-term borrowing costs relative to where they would be without them—although long-term interest rates will still go up and down depending on investors' confidence in the economy and other factors. Lower longer-term interest rates support the value of stocks, homes and other assets, increasing household wealth. As normally happens when the Fed lowers interest rates, this may lead to a moderate change in the foreign exchange value of the dollar that supports demand for U.S.-produced goods. By easing financial conditions, Fed asset purchases help foster greater spending by households and businesses, increase employment and keep inflation from falling further.

The Federal Reserve completed the $600 billion asset purchase program on June 30, 2011.

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¹ To be more precise, most policymakers aim for an inflation rate of 2 percent or a bit less as measured by the personal consumption expenditures (PCE) deflator, which equates to roughly 2 percent consumer price inflation.

Why Did the Fed Do What It Did?

Why is it the Fed's job to help support the economy?
- The Fed has a mandate from Congress to promote maximum employment and price stability. This is sometimes called the “dual mandate” because it combines these two objectives. The deep recession of late 2007 to mid-2009 and slow recovery through late 2010 resulted in unemployment that was unacceptably high (nearly 10 percent) and inflation that was below the level the Fed judges to be consistent with its mandate. Because the momentum in the economy was weak, the Fed also had to take into account the risk that some unforeseen setback might push the economy back into recession or lead to negative inflation, that is declining prices, wages, and incomes, that could further damage the economy. It was and remains the Fed's job to do what it can responsibly do to help push the economy back toward maximum employment and price stability.
What was the purpose of the asset purchase program?
- The purpose of the asset purchase program was to promote the goals given to the Fed by Congress. The Fed conducted the asset purchases because it believed they would help restore maximum employment and price stability sooner than would be the case without the purchases, while creating enough economic momentum to reduce the risk of renewed declines in jobs or inflation.
Why ever worry about inflation being too low?
- Inflation that is too low can create problems for the economy—particularly when short-term interest rates are already close to zero. In these circumstances, any decline in inflation pushes up the cost of borrowing in inflation-adjusted terms. This is bad for spending and growth. High unemployment and low demand for goods and services tend to push down inflation. At the end of 2010 inflation was already too low and unemployment quite high. If the recovery did not gain momentum there was a risk that prices could actually decline, which is referred to as deflation.
  
  While falling prices may seem beneficial, a general decline in prices resulting from falling demand can be very problematic. For example, falling prices are generally accompanied by falling incomes, and this makes it harder for borrowers to repay their debts. For example, imagine a baker who has borrowed money to buy his bakery. If the price of bread decreases, he earns less money selling bread, but his loan payments do not change. In such a scenario, indebted people have to cut back further on their own spending, reducing other people's incomes—potentially leading to more deflation.
Was the Fed just "monetizing" government debt?
- No, this was not the Fed's strategy. Monetizing the debt refers to a policy of creating new money to finance government activity. By contrast, the purpose of the Fed's asset purchases was to provide further support to economic activity, particularly private consumption and investment, and to help ensure that inflation, over time, is at levels consistent with the Fed's mandate of maximum employment and price stability. The Fed bought Treasury securities from private investors in the secondary market at market prices and not directly from the Department of the Treasury. Furthermore, the amount of the purchases was not determined by the Treasury Department.

How It Works

How can asset purchases help support the economy?
- Asset purchases ease what economists call financial conditions in the economy. The purchases lower longer-term interest rates relative to where they would otherwise be in the absence of these purchases, and they support home and stock prices—again, relative to where they would be had purchases not taken place. Both of these channels encourage spending and investment by consumers and businesses. Increased demand for goods and services promotes the hiring of new employees, pushing down the unemployment rate. In addition, there may be a moderate change in the foreign exchange value of the dollar that supports U.S. net exports. By supporting the economic recovery, and boosting confidence that the Fed will indeed ensure price stability, asset purchases also protect against the possibility of falling prices and wages, a phenomenon called deflation.
If the Fed buys only government debt how does this lower interest rates paid by consumers and businesses?
- When the Fed purchases longer-term government debt, there are fewer of these securities available for private sector investors to buy. The reduction in supply results in the price of these securities going up and the yield or interest rate charged on them going down (relative to where they would otherwise have been, taking into account factors such as the size of the government's deficit, the outlook for the economy, and so on). With less government debt available for investors to buy, they will seek to put their funds elsewhere—for example, they may buy debt of businesses or invest in shares of companies. This reallocation of funds makes it cheaper for businesses and households to borrow. For example, mortgage lenders could borrow money from investors and then offer mortgages at lower rates, making housing more affordable and reducing mortgage payments for those who refinance. Cheaper financing for businesses encourages greater investment.
How do Fed asset purchases differ from how the Fed conducts monetary policy normally?
- The Fed usually conducts monetary policy by setting a target for a short-term interest rate called the federal funds rate, which is the interest rate banks charge each other for overnight loans. By setting this interest rate and providing information to the public and the markets about what factors may influence the setting of this rate in the future, the Fed influences wider financial conditions, including the cost of longer-term borrowing for businesses and households and the value of assets such as homes and equities. Asset purchases also work by influencing these broader financial conditions. The most significant difference is that traditional monetary policy operated through the overnight interest rate. In contrast, asset purchases operate more directly on longer-term interest rates. This alternative approach was adopted because, with the federal funds rate already near zero, there was little scope to ease financial conditions the usual way.
If asset purchases work by raising prices of certain assets, then doesn't this mean that the Fed is targeting asset prices?
- No. The program did not intend to achieve any particular target price for bonds, stocks or any other asset. Instead, it was aimed at promoting maximum employment and price stability.
Did the Fed take risk onto its balance sheet when it bought Treasury securities?
- Treasury securities are backed by the full faith and credit of the U.S. government and do not carry any risk of default. However, holding these securities on the Fed's balance sheet does involve interest rate risk. If these assets are sold when interest rates are higher, then it is possible that the Fed could sustain losses on these transactions. Moreover, the net income generated from the Fed's portfolio could decline if short-term interest rates were to increase. However, a very substantial decline in Fed profits from what are currently well above normal levels to well below normal levels would likely only occur in an environment in which the economy rebounded strongly. In this scenario, any costs from diminished Fed profits would be relatively modest compared with the benefits to the nation of achieving this stronger economy.
Did the Fed's asset purchase program affect the value of the dollar?
- The U.S. dollar is a floating currency: its value is determined by buyers and sellers in the foreign exchange market and is therefore affected by financial and economic conditions both here and abroad. Whenever the Fed lowers interest rates, whether long-term or short-term rates, it may affect the dollar's exchange rates. However, the boost to U.S. demand that results from easier financial conditions benefits foreign economies that trade with the United States, as well as the United States itself. The Fed does not have a target for the dollar and did not seek to lower the value of the dollar through its asset purchase program. Moreover, asset purchases should promote a stronger U.S. economic recovery with low inflation, which is an environment that will support the dollar over time.

The Mechanics

How did the Fed decide on the appropriate amount of assets to purchase?
- The $600 billion figure was based on the Fed's review of the economic outlook and its balancing of the benefits of a given amount of purchases, in terms of promoting maximum employment and price stability, against the costs associated with the purchases. Because the assessment of the economic outlook and the benefits and costs of asset purchases could have changed over time, the Fed regularly review the program in light of incoming information and was prepared to make adjustments to its purchases as necessary to achieve its legal mandate to promote maximum employment and price stability. However, the Fed maintained the $600 billion target figure through the program’s completion.
Who did the Fed buy the assets from?
- The Fed purchases securities from a group of financial institutions called primary dealers. Although only the primary dealers trade directly with the Fed, any investor can sell securities to the Fed through the primary dealers. This is the same way the Fed has operated for decades when intervening in the markets to raise or lower short-term interest rates. Primary dealers are banks and other financial institutions that trade government securities with the Federal Reserve Bank of New York. The current list of primary dealers can be found here. To become a primary dealer, these banks agree to be regular participants in the Fed's open market operations and in auctions of U.S. Treasury debt to ensure that there is sufficient involvement in these operations—commitments that benefit taxpayers and help the Fed do its job effectively.
How did the Fed know it was getting fair prices for its purchases?
- The Fed's asset purchases were conducted through competitive auctions. In determining which offers to accept, the Fed compared each offer with the current secondary market prices of similar securities, as well as with its own assessment of the fair value of those securities, and took only those offers that appeared favorable. This procedure ensured that the Fed received the best available prices for the securities it bought.
Why did the Fed provide information about its asset purchases?
- The Fed provided guidance on the asset purchases to ensure transparency of the operations. Greater transparency encourages wider participation from investors, which helps ensure that the Fed receives fair prices on its purchases. Also, the transparency of operations helps to reduce any distortions in government debt markets from the Fed's participation.

Money and Inflation

Was the Fed printing money?
- When the Fed buys assets from the public, it pays for them by electronically crediting banks' deposits at the Fed (which are known as reserves), not by printing currency.
What effect do asset purchases have on the money supply?
- Whenever the Fed creates reserves in order to purchase assets it increases a measure called base money, which is made up of notes and coins in circulation plus reserves. However, because reserves can be held only by banks and not by households or businesses, reserves by themselves have little direct impact on economic activity or inflation.
  
  Most commonly used measures of the broad money supply include both currency and certain types of bank deposits, which in effect represent money created by banks when they make loans, but not reserves. These broad money measures tend to be more directly relevant for economic activity and inflation.
  
  When the Fed buys an asset, the effect on the broad money supply depends on who sold the assets and what they do with the funds they receive. If the seller is a bank, reserves go up, but broad money only increases if the bank responds to the increase in its reserves by lending more to households and businesses. If the seller is an investor other than a bank, reserves go up, and broad money also goes up in the first instance as the seller's bank puts a sum equal to the amount it receives from the Fed into the seller's bank account. But if the seller uses the money to pay down debt, the broad money supply declines again by the amount of the debt repayment. As of early 2011, the behavior of the broad money supply, economic activity and inflation all suggested that recent money growth had not been excessive.
Banks already have excess reserves. If they are not lending these reserves now, why would more asset purchases improve things?
- Asset purchases primarily work through their effects on longer-term interest rates, the availability and cost of credit more broadly, and asset prices. Therefore, asset purchases can affect spending even if banks initially do not lend out the extra reserves.
What measures does the Fed use to gauge inflation? Why do some measures ignore food and energy prices?
- The Fed does not ignore the prices of food and energy when monitoring inflation. It uses many different measures of price changes to evaluate overall trends in inflation and some include food and energy. However, historical experience has shown that food and energy prices are extremely volatile—they bounce around a lot. Because monetary policy works with a time lag, the Fed is most interested in the outlook for inflation a few years from now. Past experience suggests that measures of underlying inflation trends that exclude volatile food and energy prices are more accurate predictors of future inflation so the Federal Reserve tends to put more weight on these measures.
Did the Fed believe that the asset purchases would necessarily lead to high levels of inflation?
- No. As of early 2011, various measures of underlying inflation were below the levels the Fed judges to be consistent, over the long run, with its mandate of promoting maximum employment and price stability. With unemployment high, and many businesses operating below full capacity, slack in the economy continued to put downward pressure on inflation. At the same time, surveys and financial market indicators suggested that both investors and the general public continued to expect inflation to gradually return to normal levels.
  
  The Fed is committed to price stability and will not tolerate medium-term inflation above its desired level (near 2 percent² ). The Fed monitors the inflation outlook very closely and is prepared to adjust policy in order to help ensure that inflation, over time, is at levels consistent with its mandate.
  
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  ² To be more precise, most Fed policymakers judge that in the longer term, inflation in the range of 2 percent or a bit less, as measured by the deflator for personal consumption expenditures (PCE), appropriately balances the risk that adverse economic shocks could tip the economy into deflation against the benefits of low and stable inflation. An inflation rate modestly above zero also reduces the probability that the Federal Reserve will be constrained from easing policy when necessary by the zero lower bound on nominal interest rates. Such an inflation rate equates to roughly 2 percent inflation as measured by the consumer price index (CPI).
What tools does the Fed have to prevent high inflation?
- The Fed can tighten financial conditions by raising short-term interest rates again at the appropriate moment, slowing the economy and reducing inflationary pressures. It has a number of tools that enable it to do so, notwithstanding the increase in the amount of assets it holds as a result of the asset purchases and the corresponding extra reserves in the banking system. The Fed can control short-term interest rates with more reserves than usual because it can set the interest rate it pays banks on these reserves using authority granted by Congress in 2008. An increase in the interest rate on reserves will encourage banks to keep their money at the Fed rather than lend it out. If necessary, the Fed could also temporarily absorb some of the reserves through transactions that effectively offer term deposits similar to the certificates of deposit that banks offer to savers, or engage in transactions called “reverse repos” that would take some of the reserves out of the banking system for a period of time. Yet another option would be for the Fed to redeem assets as they mature or sell some of its assets, reversing some of the stimulus provided by these purchases.

Evidence in Practice

Have other countries ever instituted similar asset purchase programs? If so, how did the U.S. program differ?
- A number of countries have implemented programs that have some similarities with our own. The most famous example is Japan, which implemented a policy called quantitative easing in 2001. Some people use the same phrase to describe the Fed’s program; however, there are some important differences between the program Japan embarked on in 2001 and the Fed's more recent asset purchases. In particular, the Bank of Japan focused on increasing the level of bank reserves with less emphasis on reducing the supply of long-term assets in the market. In contrast, the Fed bought longer-term government debt, and its primary goal was not to increase bank reserves. Instead, the Fed's aim was to reduce long-term interest rates, ease financial conditions and provide lower borrowing costs for business and households. More recently, the Bank of England instituted an asset purchase program, under which it purchased longer-term assets; this program had goals similar to those of the Fed's asset purchase program.
What happened the last time the Fed bought assets?
- The Fed conducted an earlier round of asset purchases that started at the end of 2008 and was completed in the first half of 2010. The program appeared to reduce longer-term borrowing costs and support asset prices, and this likely helped the U.S. economy to stabilize and then grow modestly from mid-2009 onward. The earlier program did not result in excessive inflation; indeed inflation trended lower over this period, though it probably fell less than it would have done without the purchases.
What is the early evidence this time?
- Financial markets began pricing in Fed asset purchases from August of 2010 onward, as Fed officials began to discuss a possible new purchase program in public. Longer-term interest rates declined and equity prices rose as market participants put increasing odds on such purchases. Toward the end of the year, longer-term interest rates rose again, reflecting the improved economic outlook, as well as news of a fiscal package that would support growth in 2011, while increasing the amount of government debt issued. Longer-term rates would be expected to increase as investors became more confident in the strength of the recovery. The purpose of the Fed's asset purchases was to achieve such a recovery in order to advance the goals of maximum employment and price stability given to the Federal Reserve by Congress.

Additional Information

Fast Facts: $600 Billion Treasury Large-Scale Asset Purchase Program »

Presentation by Steve Meyer

Recent Federal Reserve Monetary Policy


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