Speculation has been building of late that the U.S. Federal
Reserve - or "The Fed" - will soon begin another round of
quantitative easing. The Fed has already
engaged in two rounds, the first running from late 2008 to mid-2010 and now known
as QE1, and again from late 2010 to mid-2011 known as QE2. So this round, if it happens, would be
QE3. Quantitative easing is not the
usual method for conducting monetary policy, but it's also not as different as
most people think.
The Fed does a great many things from bank regulation to check clearing, but one of the most important things it does is control the U.S. money supply. To see how quantitative easing operates it is useful to first examine how the monetary policy is usually conducted.
In normal times this is done through open market operations, or OMOs. When the Fed conducts an OMO they buy or sell short-term U.S. treasury securities on the bond market. The purchase of T-bills by the Fed helps spur the creation of money. When bonds are purchased, the Fed pays for them by creating an electronic credit in an account the seller's bank keeps at the Fed. These accounts are called reserve accounts and they help satisfy reserve requirement that banks must meet to back up the checking account balances they issue.
When the Fed buys bonds, it creates excess reserves that are not necessary to meet the legal reserve requirement. Reserves are safe assets, but offer a low interest rate (prior to the 2008 crisis the rate was zero) so banks often seek to loan out these excess funds and earn interest. The most immediate outlet for loans is the federal funds market where banks loan money to each other for short periods of time, usually overnight. The Fed watches the federal funds rate closely and tries to conduct OMOs that will push it into a desired range.
In 2008 the normal way broke down however. One reason for this is because the federal funds market does not operate well when banks are under stress. In 2008 banks were carrying toxic assets and those that had excess reserves chose to hold them rather than loan them out. The federal fund rate, which was already quite low, fell to zero by December of 2008.
Zero is a special number for interest rates as it is a pretty effective lower bound. As a lender, a below zero rate means you are actually losing interest when you make a loan. A better strategy would be to just hold cash. Targeting a federal funds rate lower than zero is unrealistic; and this is where quantitative easing comes in.
In order to increase the money supply it is not really necessary that the Fed buy short-term Treasury securities; any kind of purchase would do. The Fed could buy ice cream or movie tickets or any number of other goods. In 2008 the Fed began to purchase mortgage-backed securities and inject money into the economy that way. Not coincidently it also bought assets that banks and other investors were eager to unload. QE2 focused on medium and long treasury bonds and spurred a drop in long-term interest rates economy-wide. This is the essence of quantitative easing; the purchase of financial assets other than short-term Treasuries.
Some people worry that a QE3 round will lead to further debasement of the dollar by "printing" too much money. But there is no fundamental difference between purchasing long-term government debt or other financial assets and purchasing short-term T-bills, in both cases the Fed is creating reserves in exchange for promises of future payment. The only significant difference is that quantitative easing can be conducted on a much larger scale.
When interest rates are already at a lower bound of zero, the most effective way to release money is through the non-traditional method of quantitative easing. Whether this is the best policy or not may be open to debate - after all, creating lots of money means in the long-run getting lots of inflation. But there is nothing fundamentally different between QE3 and conducting monetary policy the usual way.