With the recent announcement of QE2 (quantitative easing 2), the Federal Reserve’s new round of long-maturity asset purchases, it is worth looking at some of the effects of QE1. In November 2008, the Fed announced large-scale purchases of mortgage-backed securities and debt issued by the GSEs. Its securities holdings began to climb sharply in early 2009. As shown in blue, the monetary base (a broad measure of the Fed’s liabilities) had already begun to rise several months earlier. New asset purchases for QE1 ended earlier this year.

The effects of QE1 and the other stimulative policies adopted by the Fed since late 2008 will be debated for some time to come. But notably, the green line shows that a trade-weighted index of the dollar’s value against a basket of foreign currencies has declined quite a bit. Some world leaders are unhappy about this development, but it may have helped to spur real (inflation-adjusted) U.S. exports, shown in red.

The orange line shows the yield on a 10-year inflation-indexed Treasury security, which can be used as a measure of the real interest rate. This rate has tumbled from well over 3.5 percent to negative levels. Some economists doubt that a monetary authority such as the Fed can succeed in reducing real long-term interest rates over a prolonged period, but this is a remarkably sustained trend.

Notes: The interest rate series in the graph has been rescaled (actually, multiplied by 100), so that its movements can be seen more easily. The export series has been deflated to 2005 dollars, using a chain-weighted GDP price index. The exchange-rate series, which is the Fed’s index of the value of the dollar against the “major currencies,” is scaled so that the first observation equals 1000. The monetary base is expressed in billions of dollars. Except for the exchange rate and interest rate series, all data shown in the figure have been seasonally adjusted. Detailed information on the Fed’s asset purchases and its balance sheet can be found in this series of official reports.

After its last meeting, the Federal Open Market Committee, which makes decisions about Federal Reserve monetary policy, decided to keep its holdings of long-term securities constant. The Fed was forced to look again at this issue because borrowers have been paying off the long-term debt securities already in its portfolio. This maturing debt consists mostly of Treasury bonds, mortgage-backed securities, and Fannie Mae and Freddie Mac bonds, most of which were acquired quite recently. The Fed will reinvest the repayments in more long-term Treasury bonds instead of allowing its balance sheet to shrink.

Some have referred to the Fed’s acquisition of certain assets not normally seen on its balance sheet by the special term “quantitative easing,” or QE. This term is perhaps somewhat misleading, because it implies a sharp distinction between the recent policies to which it refers and the Fed’s more typical manipulations of the federal funds and discount rates. But, surprise, the new policy actions also involve interest rates, albeit ones that the Fed had not attempted to directly influence in many years when it began QE in 2008. Let’s hear what Ben Bernanke said at a conference last week:

….changes in the net supply of an asset available to investors affect its yield and those of broadly similar assets. Thus, our purchases of Treasury, agency debt, and agency MBS [mortgage-backed securities] likely both reduced the yields on those securities and also pushed investors into holding other assets with similar characteristics, such as credit risk and duration. For example, some investors who sold MBS to the Fed may have replaced them in their portfolios with longer-term, high-quality corporate bonds, depressing the yields on those assets as well.

In other words, the Fed is buying long-term securities mainly as a means of reducing the interest rates paid by the federal government and other borrowers when they issue long-term debt. These rates are crucial because many large purchases are paid for over a long period of time. These include homes and large-scale corporate investments such as new factories, which are usually expected to yield revenues over a stretch of many years. Of course, the Fed has not set an explicit target for any long-term interest rates. But it certainly did that during and immediately after World War II, which was the last time the federal debt was so large as a percentage of GDP. (Interestingly, during its history, the Fed has not always publicly committed itself to any interest-rate target at all.)

This graph, which shows interest rates on long-term securities issued by the federal government, offers some historical perspective on just how low interest rates are:

The figure depicts two data series maintained by the Federal Reserve, which I have had to splice together because neither series covers the entire time period shown in the graph, January 1925 to July 2010. It shows that throughout World War II and until 1953, the Fed kept long-term interest rates below 3 percent, which helped keep the cost of federal debt low. Of course, to do this, the Fed had to purchase many long-term government bonds. We wonder what will happen next.

(Graph updated with August 2010 data point and resized for readability September 15, 2010.)

In the Wall Street Journal, Stanford’s Robert Hall tells Jon Hilsenrath that last year’s stimulus just about made up for the cuts in state and local government spending forced by the recession (most states have balanced budget requirements, so when tax revenues dip, as they do in a recession, spending must follow).

So, there was no net stimulus from government spending last year! Still, it could have been worse. What David Leonhardt doesn’t say (in his take on the subject for the New York Times) is that the initial stimulus was too small. Certainly state fiscal support was too small. States have still had to cut their budgets, laying off teachers and police officers. These layoffs have not been helpful to recovery, to say the least.

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About a year ago, supply-side economist Arthur Laffer (known for the “Laffer curve,” a graph that depicted tax revenue first rising, then falling as tax rates increased) published an op-ed piece in the Wall Street Journal predicting sharply higher inflation and nominal interest rates over the next four to five years. The justification given for this claim was the rapid growth of the money supply, as measured by the Fed’s monetary base statistic, since the fall of 2008.

One year later, inflation has not taken off. Meanwhile, the stock of currency and bank reserve deposits at the Fed has continued to grow rapidly, though growth has slowed markedly over the past year. The chart to the left (click on it for a better look) shows that Laffer’s preferred measure of money-supply growth has trended downward recently. It remained at about 100 percent, year-on-year, in the three months immediately following the op-ed piece. Since then, money-supply growth has remained in the double-digit range. However, there has been no discernible and sustained upward trend in nominal interest rates or inflation. Many recent events have conspired to keep these numbers at low levels. On the other hand, an argument can be made that the money supply itself is mostly a somewhat unreliable indicator of what is happening, rather than a crucial mover of the economy.

About 40 years ago, economists Nicholas Kaldor and James Tobin, both followers of Keynes, published important articles arguing that changes in the “money supply” in themselves were probably not causes of economic growth or inflation, but instead a product of those forces. (This claim does not mean that interest rates do not play an important role.) Monetarists like Milton Friedman, who had long argued that the growth rate of the money supply determined the growth rate of nominal income in the short run and inflation in the long-run, had it almost completely backwards, according to this post-Keynesian view. Granted, the Fed chooses in a literal sense the size of its balance sheet by making voluntary asset trades, loans, etc., but as a practical matter it cannot consistently maintain an arbitrarily chosen money-supply growth rate. For example, the Fed usually targets the federal funds rate. This forces it to buy or sell just enough bonds to stay at the targeted interest rate, which affects the supply of Fed liabilities in often-unpredictable ways. Attempts by central banks around the world to set and meet targets for the growth rate of the money supply have been repeatedly frustrated and, worse, have often led to recessions.

The Fed has recently expanded the range of assets it buys and sells in order to guide the economy, in what might seem more like a deliberate policy decision. (Mortgage-backed securities, longer-dated bonds, and some distressed assets obtained from failing firms and institutions are important examples of the types of assets currently held by the Fed in significant amounts.) One might assume that such purchases are well within the Fed’s power to control. But there is less discretion even in these actions than many observers seem to think. For example, in the Fed’s view and that of the federal government, a decision to ignore the AIG situation could have led to a wider financial panic, because it would have threatened investment banks and other companies with which AIG had done business. As Hyman Minsky pointed out repeatedly in his writings, working to alleviate and prevent financial crises by helping failing banks may be the most crucial of the Fed’s duties—more important even than setting interest rates. The recent crisis seems unusual only because it was by some measures the most serious challenge of its type in many years. Despite the unusual scope and size of the bailout efforts, the Fed’s overall approach set very few precedents, and wide-ranging efforts to stabilize financial institutions and markets could not possibly have been avoided without serious economic consequences, though perhaps the task could have been accomplished at a much lower cost.

Such efforts have ineluctably led to the huge money-supply growth rates that are shown in the figure. Laffer pointed out that most of this growth was due to a dramatic increase in bank reserves. However, high levels of reserves will not lead to significantly increased lending unless financial institutions believe that more loans will be repaid with a profitable return, an eventuality that in the current situation will await stronger demand for American goods and services. Anyway, because of the weakness and fragility of the recovery, many fewer economists worry about excessive lending now than one year ago.

Actions that the Fed is in effect compelled to take—either to meet an interest-rate target or to fulfill its lender-of-last resort function and similar obligations to stabilize the financial system—cannot be seen as fundamental causes of inflation. Doubtless, a failure to perform either of these key central-bank functions effectively could lead to a deeper recession and/or deflation. But even to the extent that the Fed is responsible for adverse economic outcomes, these are likely to be the result of mistakes in interest-rate policy and in stabilizing the financial system, which are best not thought of as erroneous decisions about the proper growth rate of the money supply.