The problem with QE is it works in practice, but it doesnt work in theory.

We should be clear that an interest rate near zero does not mean the Fed is paralyzed. By purchasing assets, we can increase the supply of monetary assets to the banking system, which in some circumstances can have a stimulative effect. The Fed has purchased significant quantities of assets since the end of 2008. The size of our balance sheet has gone from $2.2 trillion to around $3.9 trillion, and it continues to increase by about $85 billion per month.


The key issue, in my view, is the extent to which the benefits of further monetary stimulus are likely to outweigh the costs. Economic growth trends currently appear to be driven mainly by population growth and productivity growth, in which case monetary stimulus will only have limited and transitory effects. But further stimulus does increase the size of our balance sheet and correspondingly increases the risks associated with the "exit process" when it becomes time to withdraw stimulus. This is why I have not been in favor of the current asset purchase program.

“I have been surprised by the stability of inflation and inflation expectations.”

“Given the expansion of our balance sheet, if you told me we were heading to a $4 trillion balance sheet, $4 trillion of outside money in the system, and that inflation expectations have remained stable, and apparently as a result inflation itself has remained remarkably stable, I wouldn’t have put 99% probability on that. I would have put much less probability on that,” Mr. Lacker said in response to audience questions.

The efficacy of this effort is the subject of significant debate, even internally within the FOMC. Some who question the efficacy, including myself, note that the effect of our purchasing MBS and driving down mortgage rates has certainly assisted a robust recovery in housing, and with it, construction jobs and manufacturing and transportation of materials that go into homes… [T]he Fed’s muscling of the yield curve has brought what has been a 30-year-long bond market rally to a crescendo…

Counteracting whatever benefits one can trace to the Fed’s unorthodox policies are some obvious costs. First, savers and others who rely on retirement monies invested in short-maturity fixed-income investments, such as bank CDs and Treasury bills, have seen their income evaporate while the rich and the quick, the big money players of Wall Street have become richer still.

Second, the standard return assumptions of 7.5 to 8 percent for retirement pools, as you well know, have been dashed (though I have always felt they were already calculated on an imaginary and politically convenient basis rather than a realistic one).

Third, accompanying the Fed’s growing balance sheet we have seen a dramatic expansion in the monetary base—the sum of reserves and currency. A basic understanding of demand-pull inflation is “too much money chasing too few goods.” Thus, the excess, currently nondeployed money could prove the kindling of an inflationary conflagration unless the Fed is nimble in managing its effect as it works its way into the economy’s production and consumption of goods and services.

A corollary of reining in this massive monetary stimulus in a timely manner is that financial markets may have become too accustomed to what some have depicted as a Fed “put.” Some have come to expect the Fed to keep the markets levitating indefinitely. This distorts the pricing of financial assets, encourages lazy analysis and can set the groundwork for serious misallocation of capital.

…

Whereas before, our portfolio consisted primarily of instantly tradable short-term Treasury paper, now we hold almost none; our portfolio consists primarily of longer-term Treasuries and MBS. Without delving into the various details and adjustments that could be made (such as considerations of assets readily available for purchase by the Fed), we now hold roughly 20 percent of the stock and continue to buy more than 25 percent of the gross issuance of Treasury notes and bonds. Further, we hold more than 25 percent of MBS outstanding and continue to take down more than 30 percent of gross new MBS issuance. Also, our current rate of MBS purchases far outpaces the net monthly supply of MBS.

The point is: We own a significant slice of these critical markets. This is, indeed, something of a Gordian Knot…

There is no Alexander to simply slice the complex knot that we have created with our rounds of QE. Instead, when the right time comes, we must carefully remove the program's pole pin and gingerly unwind it so as not to prompt market havoc. For starters though, we need to stop building upon the knot. For this reason, I have advocated that we socialize the idea of the inevitability of our dialing back and eventually ending our LSAPs. In June, I argued for the Chairman to signal this possibility at his last press conference and at last week’s meeting suggested that we should gird our loins to make our first move this fall. We shall see if that recommendation obtains with the majority of the Committee.

“It is reasonable to think that an outright purchase program has more impact on inflation and inflation expectations than a Twist program,” Bullard said today in a speech in Little Rock, Arkansas. “If the goal is to keep policy on its present course, the replacement rate should be less than one-for-one.”   From the Bloomberg News summary

Responding to questions after his speech, Mr. Bullard said he would like to keep monetary policy on an even keel after Operation Twist's end, and given the desire to keep the potency of policy about the same, he said he favored the Fed buying about $25 billion a month in Treasury purchases.  From the Dow Jones News summary

In sum, the Fed's basic strategy for strengthening the economy--reducing interest rates and easing financial conditions more generally--is the same as it has always been. The difference is that, with the short-term interest rate nearly at zero, we have shifted to tools aimed at reducing longer-term interest rates more directly.

Editorial aside:  It is worth noting that Bernanke assigns no role to the increase in the supply of reserves or in the monetary base in his analysis of how the Fed's unconventional measures operate.

My own view is that except for the period when markets were severely impaired, early in the crisis, the asset purchase programs had, at best, marginal effects on asset returns and economic activity. Given that market functioning has returned to normal, I believe asset sales are unlikely to have a significant impact as market participants’ demand for risk and duration rise.

Others have suggested that we simply rely on raising interest rates and allowing the balance sheet to decline only slowly over time through the natural run-off of maturing securities. In my view, this alternative has several drawbacks. No one knows how fast the Fed might have to raise rates to restrain the huge volume of excess reserves from flowing out of the banking system. Rates might have to rise very quickly and in larger increments than otherwise to offset the accommodative impact of the large balance sheet. This could prove quite disruptive, yet failing to do so could risk much higher inflation levels.

I don't think you can print money indefinitely and be casual about what the consequences might be. You've got to be very serious that this could create a lot of inflation going forward. It has not. That's true. But this has to do with our credibility being able to move the balance sheet back to a more normal level in a reasonable amount of time.

In making our assessments about next steps, we need to be a bit humble about our capacity to forecast how market participants would respond to our actions. We do not control their behavior nor have much historical experience that we can draw on to easily assess how they are likely to behave. Even viewpoints that turned out to be incorrect could persist for a long time and generate adverse consequences. It is not enough for us to be right in theory. We also have to be convincing in practice and in explaining why concerns we think are misplaced are indeed unwarranted.

I think it is abundantly clear to the market that regardless of the language the FOMC employs to describe its deliberations and intentions, the consensus of the committee is to keep the price of money—the cost of the gas needed for our nation’s economic engine—low until the committee is confident that the gears of the economy have begun to mesh more robustly.

Which focuses attention on the size of our balance sheet and whether we will expand it. Personally, I would be reluctant to do so unless or until fiscal and regulatory initiatives are aligned with the needs of job creators. Otherwise, further accommodation might be pushing on a string.   In the worst case, it could flood the engine of the economy with gas that might later ignite inflation. Of course, if the fiscal and regulatory authorities are able to dispel the angst that they are reportedly causing, further accommodation may not be needed because the liquidity that has been built up on corporate balance sheets and in the excess reserves of banks might then be released into the economy and spur job creation.

Deposit institutions are holding over a trillion dollars in excess reserves (that is, over 15 times what they are required to hold given their deposits). These excess reserves create the potential for high inflation. Suppose that households believe that prices will rise. They would then demand more deposits to use for transactions. Banks can readily accommodate this extra demand, because they are holding so many excess reserves. These extra deposits become extra money chasing the same amount of goods and so generate upward pressure on prices. The households’ inflationary expectations would, in fact, become self-fulfilling.

Why might households expect an increase in inflation? The amount of federal government debt held by the private sector has gone up by over 30 percent since the beginning of 2008. This debt can only be paid by tax collections or by the Federal Reserve’s debt monetization (that is, by printing dollars to pay off the obligations incurred by Congress). If households begin to expect that the latter will be true—even if it is not—their inflationary expectations will rise as well.

My focus is building confidence that real growth is underway and sustainable. Because when that happens, when real growth picks up, if we don’t change policy in the face of that, then we are actually loosening policy. Because as real growth rates pick up, demand for loans is going to pick up, banks are going start converting their excess reserves into lending–which is not necessarily a bad thing, but they could do that very quickly and then all that liquidity starts flowing into the economy. That is the fuel for inflation.

In our explanations of our actions, we have concentrated, as I have just done, on the effects on the prices of the assets we have been purchasing and the spillover to the prices of related assets. The huge quantity of bank reserves that were created has been seen largely as a byproduct of the purchases that would be unlikely to have a significant independent effect on financial markets and the economy. This view is not consistent with the simple models in many textbooks or the monetarist tradition in monetary policy, which emphasizes a line of causation from reserves to the money supply to economic activity and inflation. Other central banks and some of my colleagues on the Federal Open Market Committee (FOMC) have emphasized this channel in their discussions of the effect of policy at the zero lower bound. According to these types of theories, extra reserves should induce banks to diversify into additional lending and purchases of securities, reducing the cost of borrowing for households and businesses, and so should spark an increase in the money supply and spending. To date, that channel does not seem to have been effective; interest rates on bank loans relative to the usual benchmarks have continued to rise, the quantity of bank loans is still falling rapidly, and money supply growth has been subdued.

Plosser, who is seen as one of the most "hawkish" Fed officials on inflation, reiterated he was "not worried about inflation in the near-term; my worries about inflation are in the intermediate to long-term."

Plosser told Market News the timing and pace of eventual policy tightening will depend on the economy.  "It's contingent on the path of the economy and of inflation ... It's hard to predict now what that may look like," he said.

"All the excess reserves in the banking system that are sitting there right now are not inflationary, but they could become inflationary if we're not careful," he said.

Uncertainty over the outlook for inflation “is as high as it has ever been since 1980”, James Bullard, the president of the Federal Reserve Bank of St Louis, has told the Financial Times.

...

The St Louis Fed president said he would not favour tightening policy before recovery was well-established. “You are going to need to have jobs growth and you are going to need to have unemployment declining.”

But once the recovery looked solid and there were consistent good monthly job gains, the Fed could “remove some of the accommodation”.

Mr Bullard said tightening “does not have to involve as its first step moving the federal funds rate off zero”.

Instead, he favoured at that point selling back assets bought by the Fed in the course of its unconventional easing.

Most Fed officials fear that asset sales would rock the markets and push up long-term interest rates, including mortgage rates. However, Mr Bullard said: “It seems perfectly reasonable to me.” He argued that, with proper planning, asset sales did not need to be disruptive.

Living with a bloated balance sheet for too long would risk fuelling inflation, he warned. “I am concerned that if, over a longer term, you just leave this many reserves in the system, under any ­normal theory . . . that is raw material for the money supply.”