Reply #52: STILL More Krugman

[Demeter]

http://krugman.blogs.nytimes.com/2009/03/20/fiscal-aspects-of-quantitative-easing-wonki

Fiscal aspects of quantitative easing (wonkish)

The big policy news this week has been the Fed’s decision to buy $1 trillion of long-term bonds, going beyond the normal policy of buying only short-term debt. Good move — but it’s probably worth pointing out that yes, this does expose the Fed, and indirectly the taxpayer, to some risks. And in so doing, it blurs the line between fiscal and monetary policy.

Now, the Fed isn’t taking on any serious default risk — Treasuries are backed by the full faith etc of the US government, and agency debt is de facto backed by the same, although the market doesn’t seem to believe that. Anyway, the Fed is for these purposes a government agency itself, so all this is debt between different parts of USG.

The Fed is, however, creating a new liability: the monetary base it creates to buy these bonds. In effect, it’s printing $1 trillion of money, and using those funds to buy bonds. Is this inflationary? We hope so! The whole reason for quantitative easing is that normal monetary expansion, printing money to buy short-term debt, has no traction thanks to near-zero rates. Gaining some traction — in effect, having some inflationary effect — is what the policy is all about.

The problem may come when the economy recovers, and inflation starts to become a problem rather than a hoped-for outcome. Basically, there will come a time when the Fed wants to withdraw that extra $1 trillion of money it created. It will presumably do this by selling the bonds it bought back to the private sector.

But here’s the rub: if and when the economy recovers, it’s likely that long-term interest rates will rise, especially if the Fed’s current policy is successful in bringing them down. Suppose that the Fed has bought a bunch of 10-year bonds at 2.5% interest, and that by the time the Fed wants to shrink the money supply again the interest rate has risen to 5 or 6 percent, where it was before the crisis. Then the price of those bonds will have dropped significantly.

And this also means that selling the bonds at market prices won’t be enough to withdraw all the money now being created. So the Fed will have to sell additional assets; if the rise in interest rates is at all significant, it will have to get those assets from the Treasury. So the Fed is, implicitly, engaged in a deficit spending policy right now.

My back of the envelope calculation looks like this: if the Fed buys $1 trillion of 10-year bonds at 2.5%, and has to sell those bonds in an environment where the market demands a yield to maturity of more than 5%, it will take around a $200 billion loss.

I’m not complaining; I think quantitative easing (it’s really qualitative easing, but I give up on trying to fix the terminology) is the right way to go. But we should go into it with our eyes open.