The Mechanics of Monetary Policy


(cc photo by LateNightTaskForce)

I almost want to encourage people not to read Felix Salmon’s excellent post explaining the mechanics of quantitative easing because the truth (you print money and give it directly to big banks) is ugly and would probably undermine support for a measure that I think would be useful. But instead what I’ll observe is that one of the biggest differences between “quantitative easing” and old fashioned regular easing is precisely that by convention journalists never explain how regular monetary policy works. What you hear is that the Fed decided to “cut interest rates.” But there’s not an interest rate switch behind Ben Bernanke’s desk that he flips toward cut.

Instead what happens is something very much like what Salmon describes in the QE scenario. The Fed decides that it wants short-term rates to fall and then takes the specific action of buying short-term bonds from major securities dealers. With QE2 all that’s changing is that they’re going after slightly longer-term bonds.

The only real difference here is a difference in degree. But the press tends to describe it as a difference in kind, contrasting “interest rate cuts” from “bond purchases” but in both cases you’re buying (or selling) bonds in order to cut (or raise) interest rates. Like it or not, this is how we conduct monetary policy in the United States and nothing about going bigger or smaller with quantitative easing is going to change that.

As it happens, I don’t like that idea a huge amount at this point. I think what we should be looking to do is to give the money directly to households. Instead of creating money and using it to buy $600 billion in bonds, create money and use it to send $2,000 to each American. That’s an approach that would be superior from a humanitarian standpoint even if it didn’t ultimately produce macroeconomic gains, and it would also have more political legitimacy.

Alternatively, if you want to talk about something that does look to me to be a useless giveaway to banks, consider the Fed’s habit of paying interest on “excess reserves.” This is counterproductive to the Fed’s goal of injecting more money into the economy (since reserves held at the Fed are not in the economy) but it’s a way of delivering extra profits to banks as a way of covertly recapitalizing them.