After reading Marvin Goodfriend's excellent JME article on Fed policy during the crisis I need to update an earlier post on how QE relates to conventional open market operations (OMOs). In that piece I noted that traditional OMOs keep the size of the central bank balance sheet constant and support financial market liquidity via cash injections financed from disposals of other central bank assets. This is too extreme. Standard OMOs do involve movements in the real size of the central bank balance sheet. The distinction between conventional monetary policy centred on interest rate targets, and either achieved or supported by OMOs, and recent QE strategies is that the former involves clear limits for balance sheet movements. For given reserve demand, the upper bound for the size of the balance sheet follows from the reserve supply need to enforce the lower bound for the policy interest rate. Due to such constraints on the size of the balance sheet, the scope for losses should assets lose value relative to liabilities is limited.
In contrast, unconventional monetary policy such as QE involves switching to a quantity target for monetary policy at the policy rate lower bound. It is impossible to specify an upper bound on the amount of QE necessary to restore aggregate demand to full employment levels, and as a result it is much harder to pin down upper bounds for the size of the central bank balance sheet and the losses that could arise if asset prices decline. In this sense, QE is a more risky strategy than is conventional policy when interest rates are above the lower bound. The need to secure fiscal and therefore political support for QE then follows, consistent with the line of argument in an earlier post.