Excerpted with permission from the publisher, John Wiley & Sons, from The Little Book of Economics by Greg Ip. Copyright © 2010 by Greg Ip.

The Little Book of Economics

By Greg Ip

In December 2008, the Fed hit an ominous milestone. As the U.S. economy spiraled down in the wake of Lehman Brothers' collapse, it concluded the damage to the economy would be so great that it had to cut the Federal Funds rate all the way to zero, or more precisely, to between zero and 0.25 percent. Was there anything left it could do?

Another tactic would be to buy foreign currencies in exchange for newly printed dollars, depressing the dollar's value and helping exports. But by hurting imports, this would come at other countries' expense. So a central bank that has cut short-term rates to zero is, practically speaking, out of bullets.

A soldier out of bullets still has a bayonet. The Fed did the equivalent of reaching for its bayonet. Between 2008 and 2010, it bought $ 1.75 trillion worth of Treasury bonds and mortgage-backed securities by printing money. Its balance sheet ballooned from under $1 trillion to over $2 trillion and banks' reserves skyrocketed from almost nothing to more than $ 1 trillion.

When a central bank shifts its focus to expanding its balance sheet through bond purchases rather than targeting short-term interest rates, it is called quantitative easing.This stimulates the economy in two ways.

1. When bond prices rise, their yields decline. So the Fed's buying nudged down long-term interest rates, boosting interest-sensitive spending on items like houses.

2. Since banks don't earn much on reserves, they may lend them out to make higher-returning loans to businesses and households. That's the rationale used by the Bank of Japan starting in 2001 and the Bank of England in 2009 when they tried the same thing.

In theory, quantitative easing endows the Fed with awesome power. It could buy up every U.S. bond in existence. Yet, in practice, this is the Star Trek of central banking, taking the Fed into strange new worlds with unknown consequences.
  • Political. One of the major risks of this strategy is that it could cast doubt on the Fed's political independence. When the Fed buys government bonds, it has lent money to the government. This is called monetizing the debt. Even though the Fed wasn't forced by politicians to buy the bonds, some experts do worry that this is how the government eventually copes with the national debt: by making the Fed buy it. That won't happen as long as politicians respect the Fed's independence, which George W. Bush, Barack Obama, and even Congress, despite rumblings to the contrary, have so far done.
  • Inflation. The second unknown is whether printing all that money will create inflation. Monetarists who see a tight link between all those extra reserves and inflation certainly think so. But they're probably wrong. That's because, as I noted in Chapter Five, reserves can't cause inflation if they aren't lent and spent.
  • But reserves do pose a more technical problem. To raise the Federal Funds rate, the Fed ordinarily uses open market operations to reduce the supply of reserves. That's easy in normal times when banks don't have much reserves, but harder when they have $1 trillion, which they will lend them for next to nothing even if the Federal Funds rate target is 2 percent.

    Luckily, in 2008 the Fed got a new tool to work with: the right to pay interest on excess reserves (IOER). If IOER is 2 percent, banks will keep those reserves at the Fed rather than lend them at less than 2 percent in the Fed Funds market.

    Tempting Speculators. Do zero interest rates entice hedge funds, banks, and others to plough borrowed money into risky investments? A lot of people think that's what happened when the Fed kept low rates from 2002 to 2004, bringing on the subprime crisis. And does it do the same in China and other countries who link their currency to the dollar and thus U.S. interest rates? There may be truth to this, but raising interest rates to combat speculation is a bit like using dynamite to eradicate termites: the remedy may do more damage than the problem. A more surgical response is to use regulations to limit risk-taking.

    Exit Strategy. When the economy has recovered, the Fed may want to sell those extra bonds. The reserves it created when it first bought the bonds would then disappear. Such selling should push up long-term rates, but by how much is hard to predict.