What is Quantitative Easing and What Is the Fed Trying to Accomplish?

Below is a really good explanation of Quantitative Easing (QE) and what the Fed is trying to accomplish with this policy.  Basically, when the ratio of household cash to total household market assets becomes too high the Fed applies QE to pull the money out of cash and into stocks or from a risk-off strategy to a risk-on strategy.

The article is in italics and the bold is my emphasis.  From Council of Foreign Relations:

The Federal Reserve thrilled markets last week (originally published 9/19/12) with the announcement that it would pump $40 billion into the economy each month through the purchase of mortgage-backed securities. Chairman Ben Bernanke justified this action by explaining that the Fed's tools "involve affecting financial asset prices."

Through the Fed's quantitative-easing programs, Mr. Bernanke has been trying more and more directly to push investors toward stocks and other financial assets in the belief that it will boost economic recovery. But the central bank has actually been steering asset prices for more than a decade now.

Between 1987, when Alan Greenspan became Fed chairman, and 1999 a neat approximation of how the Fed responded to market signals was captured by the Taylor Rule. Named for John Taylor, the Stanford economist who introduced the rule in 1993, it stipulated that the fed-funds rate, which banks use to set interest rates, should be nudged up or down proportionally to changes in inflation and economic output. By our calculations, the Taylor Rule explained 69% of the variation in the fed-funds rate over that period. (In the language of statistics, the relationship between the rule and the rate had an R² of .69.)

Then came a dramatic change. Between 2000 and 2008, when the Fed cut the fed-funds target rate to near zero, the R² collapsed to .35. The Taylor Rule was clearly no longer guiding U.S. monetary policy.

What happened? With the tech-bubble collapse, Japan's travails with deflation and stagnation, the turmoil following 9/11, and quiescent inflation, the Fed's focus began to shift. "New eras bring new challenges," observed Mr. Bernanke in late 2002, when he was a Fed governor. In a now-famous speech invoking the analogy of a "helicopter drop of money," he argued that monetary interventions that boosted asset values could help combat deflation risk by lowering the cost of capital and improving the balance sheets of potential borrowers.

Mr. Bernanke has since repeatedly highlighted asset-price movements as a measure of policy success. In 2003 he argued that "unanticipated changes in monetary policy affect stock prices . . . by affecting the perceived riskiness of stocks," suggesting an explicit reason for using monetary policy to affect the public's appetite for stocks. And this past February he noted that "equity prices [had] risen significantly" since the Fed began reinvesting maturing securities.

Since the collapse of Lehman Brothers in 2008, investors as a group have been jumping in and out of risky assets as sentiment shifts about the direction of government policy—Fed policy in particular. On Wall Street they call this "risk on, risk off." Since 2000, the Fed's efforts to turn markets on and off to risk have become so predictable that we've been able to infer a "rule" that is even more accurate than the Taylor Rule was in the 1990s.

Between 2000 and 2008, the level of household risk aversion—which we define as the ratio of household currency holdings, bank deposits and money-market funds to total household financial assets—explained a remarkable 77% of the variation in the fed-funds rate (an R² of .77). In other words, the Fed was behaving as if it were targeting "risk on, risk off," moving interest rates to push investors toward or away from risky assets.

As the financial crisis unfurled in 2009, our descriptive rule predicted that the Fed would want interest rates below negative 2%. That being impossible as a practical matter, the Fed began quantitative easing to mimic the effect of negative rates.

In November 2008, the Fed began its first round of quantitative easing, purchasing $1.25 trillion in mortgage-backed securities and $500 billion in government-agency debt and longer-term Treasury securities through March 2010.

In November 2010, with the economy still struggling, the Fed launched QE2, purchasing $600 billion in Treasury securities through June 2011. And now, with the recovery still sputtering, the Fed has announced QE3.

The Fed's sustained targeting of "risk on, risk off" raises the serious question of whether bubbles are now more apt to form in various markets, ultimately resulting in greater volatility and damaging crashes.

Some Fed officials have openly expressed such concerns. In 2002, James Bullard, the current St. Louis Fed president, concluded on the basis of his own studies that "including equity prices in a Taylor-type policy rule will degrade economic performance." Last year, Dallas Fed President Richard Fisher warned against the risks of the Fed encouraging the view that there is a "Bernanke put" hanging over the market—that the Fed would "ease monetary policy whenever there is a stock market 'correction.' "

It took many years for the cumulative effect of tax and regulatory incentives for risk-taking in the real-estate and securitized-lending markets to nearly sink the economy. The Fed should be wary of making similar errors through the use of monetary policy.