1. Monetary policy, the Fed & QE
A primer
Remarks by Greg Ip
U.S. Economics Editor, The Economist
To the Capital Markets Initiative
sponsored by Third Way

2. Why do we have money?
• It’s a store of value (examples of
things that act as store of value:
property, stocks, bonds, gold)
• It’s a unit of exchange (examples of
things that act as units of exchange:
wampum, gold coins, frequent flyer
miles, bitcoin

3. The BCB era
(before central banks)
• Money either consisted of coins made
from specie (gold & silver) or
banknotes convertible on demand to
specie – a gold or silver standard

4. How the gold standard worked
A bank, in normal times
Liabilities Assets
$9 notes or $9 of loans
deposits
$1 shareholder $1 of gold
equity
$10 total $10 total

5. That same bank, boom times
Liabilities Assets
$13 notes or $13 of loans
deposits
$1 shareholder $1 of gold
equity
$14 total $14 total
Credit, money supply expand
40%, result: inflation

6. The problem with gold standard
• If only a few people convert their deposits to gold, no
problem.
• If many people want to convert their deposits to gold, big
problem – not enough gold to go around
• Banks call in loans, stop repaying people their gold
• Everyone rushes to get their gold back. Result: panic!
And bank failures
• Bank panics in 1797, 1811, 1813, 1816, 1819, 1825,
1837, 1847, 1857, 1873, 1884, 1893, 1907

7. Bust
Liabilities Assets
$7 notes or $8 of loans
deposits
$1 shareholder $0 of gold
equity
$8 total $8 total
Credit, money supply shrink
40%, result: deflation

8. Solution: a central bank
• In 1913, Congress creates Federal Reserve to
supply an “elastic currency”
• When banks run short of cash, they can borrow
from the Fed
• The Fed “prints” money, lends it to banks, in
exchange for collateral,
• Later, banks repay the loans, the money is
withdrawn from circulation

9. The Fed’s two roles
• #1 Lender of last resort: to lend to solvent
banks that are temporarily short of cash, to
prevent panics and unnecessary failures.
• Problem: hard to tell when a bank is actually
solvent. Result: Depression
• #2 Monetary policy: regulate the overall supply
of credit to prevent recessions and control
inflation
• Problem: hard to know when the economy is
growing too fast or when inflation is going to rear
up. Result: 1970s

10. What causes inflation?
• Monetarist view:
• Fed prints money => too much money, too few goods =>
inflation
• Wrong! Fed doesn’t control all the money supply: only a
tiny bit, just enough to control the “Fed funds rate”
• Modern view of inflation:
• Fed keeps interest rate low => more spending, less
saving => spending exceeds economy’s ability to supply
goods => inflation
• If people expect higher inflation, they will set prices and
wages accordingly and it will be a self-fulfilling prophesy
• This is how ALL central banks view inflation nowadays

11. What causes unemployment?
• In the long run, supply: the structure of the
economy: demographics, labour market rules,
skills/technological change
• In the short run, demand. If spending rises but
does not exceed the economy’s supply, more
people will get jobs, unemployment will go down
• In spending rises and exceeds the economy’s
supply, only a few more people will get jobs; the rest
will get higher wages, and inflation will result

12. Conventional monetary policy
• If demand is falling and unemployment is rising, the Fed
lowers the short-term interest rate
• This also lowers bond yields as investors adjust to
expectations of lower rates for a while
• Result: more borrowing, spending, less saving, higher
employment
• Other effects: higher stock prices => wealth effect =>
more spending, investment
• lower dollar => more exports

13. Unconventional monetary policy
• Economy in really bad shape, people respond less to
lower interest rate because they can’t qualify for loans or
want to rebuild savings
• Result: short-term rate falls to zero and stillnot enough to
get spending up, unemployment down
• Solution: reduce long-term rates. How?
• Words: Fed says it will keep short-term rate lower
(affects bonds yields)
• Actions: Fed buys bonds, directly lowering bond yields
• How does it pay for bonds? By selling treasury bills
(“Operation Twist”)
• Or by printing money (“quantitative easing”)

14. Does QE cause inflation?
Printing money causes inflation only if the money
is lent & spent …
7.90 Money supply 3.0
(right axis)
7.70 2.5
7.50
2.0
7.30
$trn
1.5
7.10
1.0
6.90
Bank credit 0.5
6.70
(left axis)
6.50 0.0
2008 2009 2010 2011 2012

15. … or if expected inflation rises
3.5
3.0 Expected inflation
2.5
2.0
1.5
1.0
0.5
0.0
-0.5
Real bond yield
-1.0
-1.5
2008 2009 2010 2011 2012

16. Does QE reduce unemployment?
• It should, with these caveats:
• Buying Treasury bonds may reduce the cost of
borrowing for the government, but not necessarily
for corporations and homeowners
• When corporations’ bonds yields decline, they may
simply refinance debt, buy back stock, not invest
• Directly reducing mortgage yields by buying
mortgage securities directly helps homebuyers
• But many homebuyers can’t qualify for a new
mortgage

17. A lot of QE benefit swallowed up
Gap between mortgage rate paid by homeowner,
and yield on mortgage bond
Source: http://www.newyorkfed.org/research/conference/2012/mortgage/primsecsprd_frbny.pdf

18. But seems to be working
Housing starts, homebuilder sentiment

19. What could go wrong?
• Sustained low yields could produce more risk taking,
bubbles
• Solution: better regulation
• It may be hard for the Fed to undo QE, and thus
control inflation
• Solution: raise short-term interest rates
• Reduces pressure on President, Congress to reduce
the deficit
• Solution: How about a fiscal cliff?

20. Shameless self promotion
• Thinking citizen’s guide to the
economy
• Clearly written, examples,
anecdotes
• No Greek letters or charts.
• Not a crisis book
• Does explain origins of crisis,
and its consequences
• Journalism, not ideology
• Useful: explains economic
indicators and economic
concepts
• Little: half the size of most hard
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21. Thanks for listening
www.gregip.com
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