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Bernanke's Speech: How Does Quantitative Easing Work? Will It Work?

I agree with Brad DeLong's reaction to Ben Bernanke's speech:
Ben Bernanke's Speech Was... Disappointing, by Brad DeLong: I am still surprised at the Fed Chair we have. Where is the Fed Chair who was willing to try to get ahead of the problems in late 2008? Or the "Helicopter Ben" of 2003? Or the student of big downturns in Japan in the 1990s and the U.S. in the 1930s.
It's a very different animal we have today. And this speech didn't do much to convince me that he is going to do what ought to be done.
Bernanke forecasts that growth next year "seems unlikely to be much above its longer-term trend"--that is, that unemployment is likely to rise in the near term and then stay essentially stable through the end of 2011 before it even starts to think about heading down.
In this environment, now is not the time for Bernanke to talk about the costs and risks of expanding the Federal Reserve balance sheet.
And it is also not the time to talk about how monetary policy can be carried out via the Federal Reserve's communications strategy.
Since I have been fairly skeptical of how much this can help the economy -- don't expect it to have a large impact on its own -- let me outline the channels through which this might work:

1. By reducing the quantity of financial assets trading in the private sector, the Fed can lower the rate of return on these assets (which is the same as raising the price of the assets since the price of a financial asset and the interest return are inversely related). The fall in the interest rate creates an incentive for more investment and more consumption of durables, which in turn increases o0utput and employment.

2. Quantitative easing may increase expected inflation. The increase in expected inflation lowers the real interest rate (the real interest rate = nominal interest rate - the expecte4d rate of inflation). The fall in the real interest rate would have the effects outlined above, i.e. create an incentive for more investment and consumption of durables, which then spurs output and employment.

3. The increase in the price of the financial asset due to the inverse relationship between the price and the rate of return noted above. This makes people feel wealthier, and the wealth effect can spur more spending generating an increase in output and employment.

4. The Fed can also lower the risk premia on financial assets, which is another way of lowering the interest rate. Though I don't expect them to do this, the Fed could buy highly risky private sector financial assets, thereby moving them off private sector balance sheets and onto the government's. With fewer risky assets in the marketplace, average risk falls driving down interest rates, and that would, once again, have the effects on consumption, investment, output, and employment described above.

5. [update] It can also cause the dollar to weaken, i.e. change the exchange rate, which would encourage exports and discourage imports (though this assumes that other countries don't respond and offset the fall in the exchange rate).

As I said many times, I don't expect any of these to have particularly powerful effects, they create incentives for businesses and consumers to increase spending, but there's no guarantee that they will act on those incentives given the negative outlook for the economy (so fiscal policy authorities should not assume that the Fed "has this"). Again, as I've said before, you can lead the horse to low interest rate water, but there's no guarantee it will drink consumption and investment. In addition, as Brad notes, it's not clear that the size of the quantitative easing will be sufficient. However, in combination the factors listed above could, perhaps, be helpful. It's certainly better than doing nothing.