QE2 update

The latest data from the Fed reveals only a modest uptick in the Monetary Base, the measure of that part of the total money supply that is completely controlled by the Fed (bank reserves plus currency in circulation). The uptick to date doesn't yet equal the size of the Fed's QE2 purchases, and the base today is only $40 billion higher than it was at this time last year. Other measures of the money supply (M1, M2) tell a similar story: there has been no unusual growth in the amount of money in the economy. This means that a) a good portion of the Fed's QE2 purchases to date have only served to offset other factors that have subtracted reserves, and b) the extra reserves created by the Fed's QE2 purchases of Treasuries are for the most part still being held voluntarily by banks (i.e., the financial system is still risk-averse enough to want to accumulate safe assets like reserves that pay only 0.25% annual interest). In short, QE2 has not resulted in a flood of new money, but instead has served mainly to satisfy the world's demand for safe haven assets.

It's also the case that one of the stated reasons for doing QE2—to reduce long-term interest rates in order to boost the economy—has at best a mixed record. Treasury bond yields are up sharply since late August when the idea of QE2 was first floated. Yet despite higher bond yields, the economy has picked up and the equity market has enjoyed a substantial rally.

If QE2 hasn't resulted in any new money flows to the economy, and Treasury bond yields are sharply higher, can QE2 still be given credit for somehow stimulating the economy? Perhaps it deserves some credit, if only because it has all but erased investors' fears of deflation, and any reduction of uncertainty improves confidence and that in turn leads to more investment and risk-taking. But perhaps the economy was improving on its own by the time QE2 got underway. Stay tuned as we continue to monitor these important monetary developments.