Quantitative Easing: QE2

Inflation is too low and high unemployment may depress it further. The risk of deflation is what drives the Fed to employ quantitative easing as a monetary tool. Nobody knows whether this tool actually works, but the Fed thinks that by purchasing a large number of long-term Treasury bonds, they can force the public to pay more for similar bonds or invest in somethings else.

Obviously, there are risks to such a policy. The Fed could ignite too much inflation as QE is in effect "printing money". However, the Fed think they can retrieve the money lent at any time, either by selling back the bonds they buy or raising interest rates to induce banks to deposit funds with the Fed. Another risk is the creation of new asset bubbles, for example, in equities.

If QE2 fails, there are other options available to the Fed:

1. The Fed could employ a change in communication where the Fed would try to push up expectations of future inflation. This can be done by promising to keep interest rates close to zero for a long time or adopting a "price-level target".
2. A more aggressive form of QE could be employed, where an interest rate is targeted and large amounts of money are spent to achieve that. This means buying unlimited bonds and losing control of the Fed's balance sheet.
3. Buying as many Treasury bonds as Congress needs to cut all taxes on payrolls to zero for a time. (The least palatable)

Looking at the options available, the Fed is not running out of tools anytime soon.