You still see people saying, in effect, “never mind the zero interest rate, why not just print more money?” Actually, the Bank of Japan tried that, under the name “quantitative easing;” basically, the money just piled up in bank vaults. To see why, think of it this way: once T-bills have a near-zero interest rate, cash becomes a competitive store of value, even if it doesn’t have any other advantages. As a result, monetary base and T-bills — the two sides of the Fed’s balance sheet — become perfect substitutes. In that case, if the Fed expands its balance sheet, it’s basically taking away with one hand what it’s giving with the other: more monetary base is out there, but less short-term debt, and since these things are perfect substitutes, there’s no market impact. That’s why the liquidity trap makes conventional monetary policy impotent.
Here, the Fed will also be buying Fannie and Freddie mortgage backed securities as well as long term government securities. Krugman considered this avenue as well:
But why not purchase stuff other than T-bills? This can be thought of as changing the composition of the Fed’s balance sheet, rather than enlarging it; and Ben Bernanke, in happier days, thought that might be an effective policy in a liquidity trap.
There are, however, three reasons to be doubtful about this stuff:
. . . 3. The reason T-bills are an imperfect substitute for, say, corporate bonds — to the extent they are — is risk. Therefore, the reason changing the composition of the Fed’s balance sheet can move prices, to the extent it can, is because the Fed is taking on risk. This isn’t a role the central bank is meant to play; you’re sliding over into fiscal policy.
Nonetheless, I guess the Fed had to try the “Bernanke twist.” And it did — the old Fed balance sheet, in which T-bills were the vast bulk of assets, is no more. But the effects have been disappointing, especially weighed against the risk, which I know is making Fed officials very nervous.
The situation is different now because the Fannie and Freddie mortgage backed securities are already fully backed explicitly by the federal government. There is no additional risk in the Fed purchasing government backed mortgage securities.
However, the efficacy of this move as a stimulus is not so clear. At least directly, the purchase of mortgage backed securities could merely be an artificial prop for housing prices and perhaps a spur to housing activity. In theory, money that was tied up in mortgage backed securities will not be pushed to other sectors of the economy. Will it actually work that way? I guess we'll find out.
Speaking for me only
