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The Fed’s loose money policy is risky, unfair, and essential

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At least for now, quantitative easing—the central-bank practice of creating large sums of money to purchase financial assets—is no more in the U.S.: At the end of October the Federal Reserve announced it was switching off the gusher. (A day later, Japan announced it was moving in the opposite direction.)
In many quarters, the response was one of relief. Since the Fed opened for business a century ago, it has seldom, if ever, carried out a more controversial policy.

Many conservatives regard QE as a misguided attempt to subvert the currency that will inevitably lead to an inflationary spiral, a speculative bubble, or both. From the left, and even from some establishment voices, comes the charge that QE is a means of enriching the 1% and accentuating inequality. (One former Fed official described it as “the greatest backdoor Wall Street bailout of all time.”) Meanwhile, there are economists who question QE on a more basic level: It doesn’t work, they insist.

It’s easy to see where the critics are coming from. In the past six years the Fed’s balance sheet has expanded by $3.5 trillion, a figure that has a whiff of the Weimar Republic about it. And because QE has helped raise asset prices, the beneficiaries are those who own a lot of stocks and real estate: i.e., the rich. The poorest 50% of U.S. households, who possess just 1% of the country’s wealth (yes, it’s that low), haven’t seen much gain from QE.

But despite all this, the critics are wrong. QE is potentially dangerous, and it’s unfair. In certain circumstances, though, it’s essential. After a financial crisis, such as the one we saw in 2008, it can be used to prop up the banking system and help restore normal intermediation. And in a slow-growing economy where the central bank has already reduced interest rates as much as it can and where worries about the deficit rule out fiscal stimulus, QE is one of the few tools that can be used to prevent the economy from descending into a semipermanent deflationary slump—the kind of one that Japan has endured for the past 20 years.

Back in 2008–09, the Fed used QE1 to head off the risk of a Great Depression–type outcome. In 2012, when QE3 was enacted, the danger was less acute: We had slow GDP growth, high unemployment, and a low rate of inflation. Since then growth, after stalling last year, has picked up. And the jobless rate has fallen from 8.1% to 5.9%—a big improvement.

ASSET BUBBLE? In late 2008 the Fed started buying back financial instruments to keep interest rates low. About a year later the U.S. stock market took off.ASSET BUBBLE? In late 2008 the Fed started buying back financial instruments to keep interest rates low. About a year later the U.S. stock market took off.Graphic Source: S&P Capital IQ

To be sure, we don’t know precisely how much of this can be attributed to QE. However, we do know that without QE things would have been worse. Studies suggest it reduced long-term bond yields by one or two percentage points, which translated into lower rates on mortgages and other consumer loans. QE also helped the Fed devalue the dollar, a boon to U.S. exports. It also signaled that America is serious about preventing a repeat of the Japanese deflationary experience. U.S. inflation, excluding volatile food and energy items, has stabilized at about 1.7%.

Even today, though, the threat of deflation is bigger than the threat of inflation. That’s why some believe QE was withdrawn prematurely. (At October’s Fed meeting, Narayana Kocherlakota, the president of the Federal Reserve Bank of Minneapolis, dissented from his colleagues’ decision.) History provides some support for the doves’ concern: Twice in the past five years the Fed has turned off the spigot, only to be forced to reverse course when the economy sputtered.

Right now, GDP growth and job creation look pretty solid. That’s the justification Janet Yellen and her colleagues cited for halting their asset purchases, and I don’t doubt their word. But I suspect they also had another motivation that wasn’t publicized. If the economic weakness in Europe and Asia spreads to the U.S. next year, the Fed will need to respond, and QE is about the only weapon left in the armory. Rather than expend all its firepower now, it decided to keep some in reserve.

John Cassidy is a Fortune contributor and a New Yorker staff writer.

This story is from the December 1, 2014 issue of Fortune.