Will Quantitative Easing Work

The critical questions for monetary conditions going forward are whether/when quantitative easing (QE) will succeed in boosting the economy and when and how it will be withdrawn. Nobody knows where Agency and Treasury yields would be without QE but I think the Fed is content that Agency spreads over Treasuries have come back to about 55bps compared with 90bps and higher in January while 10 year Treasury yields have held near 3% despite very heavy issuance.

In theory QE works by pulling down long term yields and then lowering risk spreads as investors go out on the maturity and risk spectrum. This, in time, should lead to more borrowing, lending and spending. A rise in stock prices is also to be expected and, hopefully, the rally we are seeing is part of the process. However, the time lags for QE are probably the same as for monetary policy generally, long and variable. Much also depends on confidence.

Assuming the economy is expanding again in 2010 how quickly will the Fed move to reverse course? I expect that the Fed will move slowly because of the danger of a sudden lurch higher in long-term yields. To reduce the danger of such a rise, the Fed will probably want to withdraw much or all of the QE purchases made this year before it starts raising the Funds rate. The Fed might even give guidance that it will be in no hurry to raise the Funds rate. This would help to anchor short rates at low levels for longer and if inflation is between 0-1% as we expect, there will be little risk in doing this.

A further way to reduce the tendency for long yields to rise sharply would be for the Fed to hold on to some of the long term bonds and instead sell shorter debt into the markets. I do not expect a rise in the Funds rate until 2011.