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The End of QE2: Did It Work? What Will Happen Next?

Today marks the last day of the Fed's financial asset purchase program known as QE2. What impact did QE2 have? What should we expect to happen now that it is ending?

Did QE2 Work?
Traditionally, the Federal Reserve stimulates economic activity by lowering the short-term interest rates. A fall in the short-term interest rate reduces the cost of borrowing, and the hope is that this will lead to increased investment and increased consumption, particularly of consumer durables purchased on credit.

But when short-term interest rates are already near zero and cannot be lowered any further, this type of policy is unlikely to have a large effect. Does this mean there's nothing the Fed can do to help the economy?

Fortunately, as Tim Duy and I note here, there are other ways for monetary policy to stimulate economic activity. When policy is eased, it also raises the price of stocks and other assets, weakens the value of the dollar, and changes expectations of future inflation. In addition, even when short-term rates are near zero, there can still be room to lower long-term rates.

When all of the various channels for monetary policy to impact the economy are taken into account, it's clear the policy worked. QE2 increased asset values leading to an increase in wealth and a noticeable impact on consumption, it reduced equity volatility and narrowed corporate bond spreads and thus played an important stabilization role, and the downward pressure on the exchange rate encouraged exports (see here for a nice infographic from the WSJ on the effects of QE2).

However, although the effects were noticeable, they were not very large, certainly far short of what we needed to lift the economy out of the doldrums. Because of this, many conclude QE2 wasn't very effective.

But the evaluation of the policy must be in terms of its main goal. As Bernanke made abundantly clear in his last press conference, the main goal of QE2 was preventing deflation. Inflation expectations as measured by 10-year inflation protected treasury securities had plunged to 1.49 percent prior to the Fed's actions last fall, and subsequently rebounded as high as 2.64 percent. By this measure, there's no doubt that the program was a success.

What Will Happen When the Program Ends?
The asset purchases made under QE2 expanded the Fed's balance sheet considerably. However, once the program ends the Fed plans to hold the balance sheet at its present size (e.g. by reinvesting the proceeds of any securities that mature while in their possession).

The effects of QE2 described above depend mostly upon the size of the Fed's balance sheet, and since the balance sheet is not expected to change until the economy shows signs of improvement, the end of QE2 will not bring about any big changes.

The wildcard here is when the Fed will begin reducing the size of its balance sheet. The first sign of this will be when the Fed stops reinvesting the proceeds from maturing securities, and the next step will be actual asset sales (both of these steps are expected before the Fed raises interest rates).

When the Fed begins this process, something I don't expect until at least the end of the year and probably after that, the effects of QE2 will begin to be reversed. But until that time the end of the program should not produce any notable economic effects.