By Conner Reagan
In November of 2008, in an effort to combat the effects of the Global Financial Crisis, the Federal Reserve implemented an unprecedented monetary policy of Quantitative Easing (QE): a practice aimed at increasing economic activity by buying large amounts of financial assets, mainly in the form of government and corporate bonds. Most recently in 2020, the Fed introduced its fourth round of QE to increase the money supply and alleviate the economic hardship caused by the Covid-19 pandemic. While QE appears to be effective in spurring economic activity, it raises questions regarding central bank independence and whether some aspects of QE are beyond the scope of the Fed’s responsibilities.
Under normal economic conditions, the federal funds rate is the primary tool used by the Fed to meet their unemployment and inflation goals. During economic downturns, the Fed can decrease interest rates to incentivize spending and increase economic output. However, in cases where interest rates have hit the Zero Lower Bound – that is, when short-term nominal interest rate is at or near zero – the Fed cannot lower interest rates further, and must look to alternative forms of monetary policy to stimulate growth. This was the case both in 2008 and 2020, and the Fed introduced QE as an alternative to bolster the economy.
The implementation of QE works in a variety of ways to increase output. By purchasing large amounts of government bonds at an above-market rate, the Fed essentially pushes cash into the economy and increases the overall money supply. More specifically, the purchasing of both government and private bonds lowers debt service costs for corporations. As the Fed buys massive amounts of government bonds, the yield is no longer competitive and institutional investors tend to shift from government bonds to blue chip corporate bonds. This investment shift towards corporate bonds increases the price and decreases the yield on those bonds, ultimately decreasing corporations’ debt service costs. Additionally, corporations have more money on hand as more of their bonds are purchased. The same decrease in debt service costs occur when the Fed buys corporate bonds directly. This overall decrease in financial costs allows corporations to reinvest in their companies by hiring workers and increasing production– ultimately boosting aggregate demand and economic output.
Although there is some preliminary evidence to suggest QE may help to increase output in the economy in the uniquely challenging situation presented by the Zero Lower Bound, several counter arguments may be leveled against the policy on the grounds that it does not fairly distribute its benefits. First, the decreased debt service costs derived from QE’s incentive to push institutional investors to buy blue chip corporate bonds as a next-best alternative to government debt disproportionately benefits large corporations relative to small businesses and individual households. The corporate bond market– also known as the Shadow Banking Market– is only accessible to a select number of established, large firms. Since institutional investors will turn first to reliable, large firms to source reliable financing, small businesses and individual households, shut out of the corporate shadow banking market, are themselves unable to directly benefit from any decrease in debt service costs. While individuals and small businesses may benefit from QE indirectly when corporations reinvest the newfound money into hiring and capital projects, there is no way to know what corporations will actually do with the additional profits. In fact, corporations are legally and financially obligated to maximize shareholder profits and the newfound cash may be directed towards stock buyback-schemes, rather than long-term capital projects. Regardless of how the increase in corporate profitability is used, it is clear that small businesses and households are unable to benefit directly from a decrease in debt service costs afforded to corporations.
Perhaps the most concerning aspect of QE, however, is that it represents a major shift in the role of the Federal Reserve – specifically as it relates to the purchase of private bonds. Before 2008, the Federal Open Market Committee’s (FOMC) scope of responsibility was confined in large part to managing federal-funds rate, a function it has undertaken with little controversy for nearly a century. Other functions, such as issuing currency and conducting limited regulatory oversight of the financial sector, have also drawn similarly limited attention. But with the introduction of QE, the Federal Reserve expanded its role to one of resource allocation. When the Fed purchases private bonds, it must decide which companies’ bonds to purchase (i.e. which companies to grant relief to). This issue was highlighted in June of 2020 when the Fed held debt from companies such as Microsoft, Home Depot, Apple, and Goldman Sachs (Cox 2020). Congress, a political institution with clear electoral accountability, regularly engages in resource allocation. But, they do so as an elected government body; the Fed, being an institution whose leaders are appointed, rather than elected, lacks the same mechanisms for political accountability. By purchasing specific private bonds, the Fed engages in resource allocation without a democratic mandate. This, in turn, has invited criticism that the Fed is able to pick “winners” and “losers” within the corporate bond market with little democratic accountability.
One way to alleviate potential concerns over the Fed adopting a broader scope of responsibility is to expand government oversight of the Fed’s decision making. The thinking behind this approach is that if the Fed seeks to expand its allocative role, elected and democratically accountable leaders should have greater oversight of such activities. However, more government intervention inherently hurts the central bank’s credibility as an independent institution and, as Alesina and Summers (1993) suggest, central bank independence is directly related to improved economic performance.
By contrast, however, one could argue the practice of QE in itself damages the Fed’s credibility as an impartial and politically disinterested organization, and exceeds the scope of central bank duties. Nonetheless, the introduction of quantitative easing appears to represent a new era of expanded monetary power for the Federal Reserve. Whether this broadened discretionary policy is warranted or not is less clear; regardless, it is a conversation worth having.
Work Cited:
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