Today the Federal Reserve, America’s central bank, will be concluding one of their regular meetings of the Federal Open Market Committee (FOMC), which sets monetary policy stance and actions for the Federal Reserve. After a speech at Jackson Hole, Wyoming, and due to strong hints in previous Fed minutes, there is widespread expectation of quantitative easing in their policy statement, to be released after the meeting on September 13th, 2012 at 12:30pm EST.

I thought I would take a moment to describe why this might or might not happen, and also what “quantitative easing” really means.

To start with, we should discuss what normal Fed actions look like. Whenever you hear about the Fed’s “interest rate”, the interest rate they are adjusting is the overnight lending rate between banks in the Federal Reserve system. The actual name is the Fed Funds Rate. Now, the Fed cannot just change that rate by dictum, so what they do is buy or sell short-term Treasuries until the overnight lending rate moves to their target.

Well, how does buying and selling short-term Treasuries change the overnight lending rate? When the Fed buys Treasuries, it does so by creating fresh money – “money printing” if you will, although no ink is actually used. And by increasing the supply of money, the relative scarcity declines, so lender banks are not able to charge as high of an interest rate for an overnight loan to another bank. And when the Fed wants to raise the interest rate, the opposite happens: Treasuries are sold back to the market, removing money from the banking system, increasing the relative scarcity of money, and banks find they can charge more interest for those overnight loans.

So that is how the Fed targets an interest rate. Well, what does quantitative easing mean?

Quantitative easing is essentially the same as regular monetary policy, but it happens when the overnight lending rate has already reached zero. When it appeared the U.S. economy was headed towards a recession in 2008, the Federal Reserve began to cut their target interest rate. They started at 5.25%, and by early 2009 they had lowered the target rate to between 0% and 0.25%. Essentially, zero!

Now what to do? The economy was clearly in free-fall. But with the Fed Funds Rate already at zero percent, many said the Fed had “run out of ammunition“. So instead of going into steady-state (maintaining the current rate), the Fed announced programs to buy large quantities of mortgage-backed securities and Treasury securities. Eventually this program would become known as “quantitative easing 1″ or QE1. The idea was to continue easing financial conditions broadly and reduce lending rates that were spiking in the economy by flooding the market with more money. And largely, it seemed to have worked to stop the fall, but didn’t create a recovery either. So while the Fed was watching for signs of a recovery, they stopped expanding the money supply. But by August of 2010, it became clear that inflation was falling and the recovery was faltering. On November 2010 the Fed formally announced that they would be purchasing an additional $600 billion over approximately six months, with the intent to foster lower lending rates, easier financial conditions economy-wide, and prevent price deflation. This would end up being called QE2.

What was most interesting was that in August of 2010, Ben Bernanke gave a speech at Jackson Hole, Wyoming, that strongly suggested the Fed would pursue more Treasuries purchases in order to help spur a stronger recovery. And on that very same day, interest rates on Treasuries started rising, inflation expections began to rise, and the stock markets rose. Wow! And the Fed hadn’t even *done* anything yet! Just on expectations of future policy, the market and economy moved *today*.

The Fed was beginning to learn the usefulness of explaining what they will do in the future to move the economy today.

So later in 2010 they also began to provide “forward guidance” for that Fed Funds Rate. The rate was at zero – but for how long? The Fed started committing to keep the Fed Funds rate low until late 2013. Eventually they moved that out to late 2014.

Still, this did not seem to move unemployment down or output up by very much. What is left?

This is where goal setting comes in. It’s one thing to say you are going to create $600 billion dollars. Should that expand the economy? Maybe, but will that money be pulled back as soon as inflation picks up? And likewise with the low interest rates “until 2014″ – is that unconditional, or could that be pulled back? Or is it a promise to raise rates after 2014? What if the economy has not recovered by then?  What should markets expect?

The Fed is slowly moving towards setting their forward guidance to be based upon an economic recovery. And this is the most effective policy the Fed can take – explicit targets. They could do it by engaging in quantitative easing until the economy returns to past long-run growth rate (about 5% year-over-year), or they could just promise to keep the Fed Funds rate low until the economy returns to the past long-run growth.  But the goal, the target is the key.

To build an analogy, let’s say I wanted to drive to Seattle. First I say I’m going to drive 600 miles, then stop and see if I made it. But I didn’t make it, so I say I will keep driving until late Friday. But I still didn’t make it. It appears my goals weren’t very conducive to making it to Seattle.

But if I set a goal to drive to Seattle, and continue driving no matter how many miles and days it took – that is a worthwhile and understandable goal. Because it isn’t about how far I want to drive, or about how long I want to drive, but it is the destination that’s key. And so it is with the Fed, they just need to indicate their destination. Let’s hope they do it.