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What exactly is quantitative easing? Part 1

10 year bond yield historicalEnlarge GraphThe dual mandate

The Federal Reserve is entrusted with monitoring the U.S. money supply, supervising the banking system, and using monetary policy to drive the economy. The Fed’s role in driving the economy is based on a dual mandate – that the Fed must fight inflation and maximize employment. The Fed had a sole mandate of fighting inflation until the Carter Administration.

The dual mandate requires the Fed to focus on inflation and unemployment.  The dual mandate was instituted because politicians believed that the Fed was too concerned about protecting Treasury bond holders at the expense of workers. In other words, it was a capital vs labor issue. Quantitative easing is a direct result of the dual mandate. While the Fed fears inflation, it fears deflation more. And the purpose of quantitative easing is to prevent deflation.

Paul Volcker was the last inflation-fighting Federal Reserve Chairman. He replaced G William Miller, a dove that Carter appointed that was an absolute disaster. Miller’s term lasted only a year and a half and was marked by high inflation. Carter nominated Paul Volcker to replace Miller and Volcker is credited with breaking the back of 1970s-style inflation. His tightening caused the 1981-1982 recession which was at that time the deepest recession since the Depression. The 1981-82 recession had higher unemployment than the Great Recession.

Criticism of the dual mandate

One of the biggest criticisms of the dual mandate is that the Fed’s tools aren’t really suited for expansion. Economists refer to this as “pushing on a string.” When the Fed wants to cool off the economy, monetary tools are very effective. In other words, the Fed can pull the economy down very well. On the other hand, during a contraction, the Fed’s expansionary efforts may have little effect. Hence the “pushing on a string” metaphor.

There has been some debate over the dual mandate in that it possibly causes asset bubbles. The dual mandate tells the Fed that they must keep interest rates as low as they dare as long as inflation remains in check. Many believe that this mandate forms the basis for asset bubbles. Asset bubbles have been a part of the landscape for the past 15 years as we went from a stock market bubble to a real estate bubble.

Many believe that the real estate bubble was a direct result of the Fed’s attempts to make up for the wealth lost when the equity market bubble burst. Since paper wealth was driving consumption, the Fed may have pursued expansionary monetary policies in order to put the wealth effect genie back in the bottle.

Quantitative easing is the latest tool the Fed is using in pursuing its dual mandate – maximizing employment while keeping inflation in check.

What exactly is quantitative easing Part 2