In the current setting, it appears that economic activity is expanding and inflation is higher than it had been. One may choose to interpret this as resulting from the Fed's quantitative easing. However, I am not signing onto that one. I recall reading recently that QE 2 was basically canceled out by offsetting changes in Treasury funding operations. That is, as the Fed bought more long-term bonds, the Treasury issued more long-term bonds relative to short-term securities.
It is true the Treasury appears to be undermining QE2 by preventing the average duration of treasury securities from decreasing. The point of shorting the average duration is to cause a portfolio readjustment that will ultimately lead to more nominal spending. Here is how I described this process:
Currently, short-term Treasury debt like T-bills are near-perfect substitutes for bank reserves because both earn close to zero percent and have similar liquidity. In order for the Fed to get investors to spend some of their money holdings it must first cause a meaningful change in their portfolio of assets. Swapping T-bills for bank reserves will not do it because they are practically the same now. In order to get traction, the Fed needs to swap assets that are not perfect substitutes. In this case, the Fed has decided to buy less-liquid, higher-yielding, longer-term Treasury securities. Doing so should lower the average maturity of publicly-held U.S. debt. It should also overweight investor's portfolios with highly-liquid, lower-yielding assets and force investors to rebalance them. In order to rebalance their portofolios, investors would start buying higher-yielding assets like stocks and capital. This would ultimately drive up consumption spending--through the wealth effect--and investment spending. The portfolio rebalancing, then, ultimately cause an increase in nominal spending. Given the excess economic capacity, this rise in nominal spending should in turn raise real economic activity.
Arnold is skeptical this portofolio balancing channel is working because of Treasury's actions. He may be right. Treasury's actions are probably preventing some of the portfolio rebalancing that would otherwise be occurring because of QE2. But Treasury is not completely thwarting QE2. QE2 appears to be raising nominal expectations that in turn are causing the investors to rebalance their portofolios. Here is how this shaping of nominal expectations should work:
If the Fed could convince investors that it is committed to the objective of higher nominal spending and higher inflation... then much of the rebalancing could occur without the Fed actually buying the securities. For if investors believe there will be a Fed-induced rise in nominal spending that will lead to higher real economic growth and thus higher real returns, they will on their own accord start rebalancing their portfolios toward higher yielding assets. Likewise, if investors anticipate higher inflation, then the expected return to holding money assets declines and causes them to rebalance their portfolios toward higher yielding assets. In other words, by properly shaping nominal expectations the Fed could get the market to do most of the heavy lifting itself. I believe this is why QE2 is still having some effect despite the Treasury working against it.