Apparently, it can happen here. On December 16, 2008, the Federal Open Market Committee (FOMC), in an effort to fight what was shaping up to be the worst recession since 1937, reduced the federal funds rate to nearly zero.

From then on, with all of its conventional ammunition spent, the Federal Reserve was squarely in the brave new world of quantitative easing. Chairman Ben Bernanke tried to call the Fed’s new policies “credit easing,” probably to differentiate them from what the Bank of Japan had done earlier in the decade, but the label did not stick.

Roughly speaking, quantitative easing refers to changes in the composition and/or size of the central bank’s balance sheet that are designed to ease liquidity and/or credit conditions. Presumably, reversing these policies constitutes “quantitative tightening,” but nobody seems to use that terminology. The discussion refers instead to the “exit strategy,” indicating that quantitative easing (“QE”) is looked upon as something aberrant. I will adhere to that nomenclature here.

This lecture begins by sketching the conceptual basis for QE: why it might be appropriate, and how it is supposed to work. I then turn, first, to the Fed’s entrance strategy—which is presumably in the past, and then to the Fed’s exit strategy—which is still mostly in the future. Both invite some brief comparisons with the Japanese experience between 2001 and 2006. Finally, I take up some questions about central bank independence raised by quantitative easing before briefly wrapping up.

The conceptual basis for quantitative easing: the liquidity trap
To begin with the obvious, I think every student of monetary policy believes that the central bank’s conventional policy instrument—the overnight interest rate (“federal funds” in the United States)—is more powerful and reliable than quantitative easing.

So why would any rational central banker ever resort to QE? The answer is pretty clear: Under extremely adverse circumstances, a central bank can cut the nominal interest rate all the way to zero and still be unable to stimulate its economy sufficiently.3 Such a situation, in which the nominal rate hits its zero lower bound, has come to be called a “liquidity trap” (Krugman, 1998), although that terminology differs somewhat from Keynes’ original meaning. ...

Read Full: Quantitative Easing: Entrance and Exit Strategies

PDF format, 492KB, 25Pages.

Alan S. Blinder, Princeton University
CEPS Working Paper No. 204
March 2010

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