Did Ben Bernanke Implement QE before the 2008 Financial Crisis?

Quantitative easing refers to the Federal Reserve’s large-scale asset purchases. The term has become a buzzword among commentators and economists over the last decade. Often forgotten in discussions about quantitative easing is that most of the funds created to make the asset purchases are not allowed to circulate in financial markets. Instead, the Federal Reserve pays banks to hold these reserves instead of lending them out.

One might expect that the net effect of quantitative easing (QE) on economic activity is neutral since the newly created money does not actually circulate in the economy. “The problem with QE,” Ben Bernanke once quipped, “is that it works in practice but it doesn’t work in theory.” While somewhat catchy, this comment does not quite reflect Bernanke’s beliefs. He believes that QE operates through a portfolio balance channel that encourages banks to reinvest funds earned from assets sold to the Federal Reserve in search of positive returns. 

Concerning the effectiveness of QE, Stephen Williamson of the St. Louis Fed has opined:

Evaluating the effects of monetary policy is difficult, even in the case of conventional interest rate policy. With unconventional monetary policy, the difficulty is magnified, as the economic theory can be lacking, and there is a small amount of data available for empirical evaluation.

QE certainly played a role in preventing the collapse of financial institutions that were holding overvalued mortgages. We also know that QE impacts resource allocation. For example, the accumulation of mortgages by the Federal Reserve tends to lower mortgage rates and encourage consumers to purchase homes. It is no coincidence that the recent accumulation of mortgages by the Federal Reserve has been accompanied by a boom in the housing market. 

The aggregate effect of QE on investment and total expenditures, however, is ambiguous. But this has not stopped experimentation with and widespread adoption of the policy by the Federal Reserve and central banks around the world.  

Proto-QE

One form of QE has mostly gone unnoticed by academics, journalists, and financial markets commentators. Before the crisis in 2008, it appears that the Bernanke Fed had already been experimenting with quantitative easing. Jeff Hummel and John Tatom have identified the experimentation.

In 2007 and 2008, the Federal Reserve reallocated credit from the market for US Treasuries to the overnight lending market. In aggregate this looked like a divergence between the Fed’s balance sheet and circulating base currency. If we take QE to be the practice of expanding the value of Federal Reserve assets holdings without a proportional expansion in circulating currency, then we can identify proto-QE expansion where the rate of expansion of the assets side of the balance sheet is persistently greater than the rate of expansion of currency in circulation.