The Fed announces its plans for quantitative easing

The Federal Open Market Committee (FOMC) announced the start of an aggressive policy of quantitative easing, stating it would purchase up to $1.75 trillion (£1.21 trillion) of assets last week.

The measures include an additional $750 billion to be spent on mortgage-backed securities, taking the total purchases of the asset class by the Federal Reserve to $1.25 trillion. An extra $100 billion was allocated to purchase agency debt, pushing total debt buying up to $200 billion, and $300 billion going towards buying long-term Treasury bonds.

While a policy of quantitative easing was generally expected, the size of the package was much larger than markets had anticipated. Many saw it as akin to electric shock treatment to stimulate lending after actions taken to unfreeze credit markets up to this point have failed to have the desired easing effect.

Economists have said the plans reveal what the Fed sees as the key areas in which it needs to intervene.

The Bank of England is buying up gilts in the secondary market, effectively increasing money supply to stimulate aggregate demand. In contrast, the Fed’s plans have been heavily weighted to buying up mortgage-backed securities with the aim of bringing down mortgage rates. The $300 billion allocated for buying up long-term Treasuries is modest relative to the size of the country’s Treasury market and might well need to be expanded in the future, says Mike Lenhoff, the chief strategist at Brewin Dolphin.

Despite concerns over the longer term consequences of expanding money supply in such an aggressive fashion, many economists were pleasantly surprised by last week’s announcement. The worry now is that while it is a positive step for the American economy, the consequent devaluation of the dollar could have consequences for other markets.

“It does to some extent change the [weak pound] story but for Britain the EU is a much more important market,” says Gabriel Stein, the chief international economist at Lombard Street Research. “The rise in the euro [against the dollar] is bad for Germany and catastrophic for Italy.”

To protect against these impacts, Stein says the European Central Bank (ECB) could decide to follow its own quantitative easing policy, although it is not obvious what assets it would buy. If its aim was simply weakening the currency rather than stimulating the economy, however, such measures could run the risk of “promoting competitive devaluation”, says Stein.