Needed: A Federal Reserve Exit from Preferential Credit Allocation

Quantitative Easing programs between 2008 and 2015 dramatically transformed the Fed’s balance sheet in size, in liability composition, and in asset composition. While the QE programs accelerated the monetary base (M0) at an unprecedented rate, they did not accelerate the quantity of money held by the public as measured by the standard broad-money aggregate M2, which has hardly budged from its pre-2008 path. In this sense Quantitative Easing was not a change in monetary policy. The Fed deliberately neutralized the effect of M0 expansion on M2 by paying interest on reserves so that banks will sit on excess reserves rather expand deposits in proportion. The combination of QE IOER, not being a monetary policy, is better understood as a preferential credit allocation policy. By holding $1.7 trillion plus in mortgage-backed securities, Federal Reserve officials risk not their own money but that of taxpayers, and substitute their judgment for the financial market’s about the right prices of mortgage-backed securities and the proper share of funds that should go to housing. This preferential policy harms efficiency (it directs scarce real loanable funds toward lower-payoff investments) and creates political economy problems (socially unproductive lobbying efforts, moral hazard, and cronyism).