Quantitative easing isn't dead, just taking a vacation
By Peter Morici
The Fed needs to maintain large levels of reserves to control interest rates
As long anticipated, the Federal Reserve will begin this month gradually winding down the $3.7 trillion in Treasury and mortgage-backed securities (https://www.wsj.com/articles/the-fed-a-decade-after-the-crisis-is-about-to-embark-on-the-great-unwinding-1505746843) it purchased in the wake of the financial crisis. But don't mourn the death of quantitative easing -- the Fed will keep a much larger balance sheet than in the past and in the future return to QE as a principal tool of monetary policy.
Historically, the Fed regulated interest rates by targeting the overnight rate commercial banks paid to borrow reserves held at the Fed by keeping a tight rein on excess reserves in the banking system and buying and selling short term Treasury securities. By regulating the federal funds rate, the Fed could push up and down the entire yield curve and influence the availability of short- and long-term credit to businesses and home buyers.
During the financial crisis, the Fed discovered that increasing reserves on the books of banks and pushing down the federal funds rate had little impact on their willingness to lend. They simply piled up reserves as they became more concerned about getting repaid on new loans and managing all the bad debt on their books.
And just prior to the financial crisis, the Fed discovered that when it raised the federal funds rate, long-term Treasury and mortgage rates moved much less than in the past. When Ben Bernanke raised the federal funds rate in 2004-2006, those rates hardly budged, (https://twitter.com/PMorici1/status/671649700613906433/) because the Chinese government was purchasing U.S. bonds at a maddening pace to keep the yuan cheap against the dollar.
More recently, as the Fed raised the federal funds rate target range (https://www.federalreserve.gov/monetarypolicy/openmarket.htm)from 0%--0.25% to 1%--1.25% from December 2015 to June 2017, the 10-year Treasury (https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield) and 30-year mortgage rate (http://www.freddiemac.com/pmms/pmms30.html)hardly budged, because the Bank of Japan and European Central Bank were aggressively purchasing long-term bonds and other assets driving investors in their markets to the United States in search for yield.