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What is QEII?

What is QEII? Quantitative easing, which the Fed has done once already (known as QEI) and is about to do again (QEII), can be understood through a device called the yield curve. The yield curve shows how the expected return on financial assets changes with differences in the maturity of the assets:

The horizontal axis shows the time to maturity, with overnight financial assets such as the federal funds market on the left and 30 year assets such as mortgages on the right. Other maturities, e.g. 3 month, 6 month, one year, 5 years, 10 years, 20 years, etc., lie between these values. The vertical axis shows the expected return on the assets. The curve generally slopes upward due to the extra return that is required to induce people to tie their money up for longer and longer periods of time.

Prior to the housing bubble, the Fed was able to shift the entire yield curve up and down by buying and selling short-term Treasury bills. Thus, the Fed had control of both long-term and short-term interest rates:

However, during the housing bubble but prior to its collapse, the Fed seemed to lose control over the long end of the yield curve. Buying and selling short-term T-Bills no longer seemed to have much impact on long-term interest rates:

Since it is predominantly long-term rates that determine business investment, the purchase of new homes, and the purchase of consumer durables such as cars and refrigerators, this was of concern within the Fed. But the reason for this was never fully understood, and the crisis diverted attention away from this issue. However, one way the Fed can potentially overcome this problem is to buy and sell longer term Treasury bonds, i.e. those that exist on the long end of the yield curve, to bring long term rates up or down as desired.

This is, essentially, all that QEII is. It is conventional monetary policy that operates at the long end of the yield curve through the buying and selling of long-term financial assets rather than through the more traditional buying and selling of short-term assets.

However, the need to operate at the long end of the yield curve presently is not because the Fed has lost control of long-term rates as it seemed to prior to the crisis -- that control returned once the bubble popped. It's because the Fed can no longer move rates at the short-end.

Presently, the Fed cannot operate at the short end of the yield curve because the short-term rate the Fed generally targets â€"- the overnight federal funds rate -- is at or very near zero. Operating at the short-end of the yield curve doesn't do much good since those rates can't come down any further. However, the Fed can still bring down rates at the long-end:

The hope is that the fall in rates at the long end will spur new investment and consumption (along with other effects such as an increase in net exports due to a fall in the exchange rate, though see here for a denial that the Fed is intending to change the value of the dollar with QEII).

So that's QEII. It's nothing more than conventional monetary policy moved out along the yield curve.

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