Quantitative Easing (QE) describes a form of monetary policy used by central banks to increase the supply of money in an economy when the bank interest rate, discount rate and/or interbank interest rate are either at, or close to, zero.
A central bank does this by first crediting its own account with money it has created ex nihilo (“out of nothing”). It then purchases financial assets, including government bonds and corporate bonds, from banks and other financial institutions in a process known as open market operations. The purchases, by way of account deposits, give banks the excess reserves required for them to create new money by the process of deposit multiplication from increased lending in the fractional reserve banking system. The increase in the money supply thus stimulates the economy. Risks include the policy being more effective than intended, spurring hyperinflation, or the risk of not being effective enough, if banks opt simply to pocket the additional cash in order to increase their capital reserves in a climate of increasing defaults in their present loan portfolio. Expansionary monetary policy typically involves the central bank buying short-term government bonds in order to lower short-term market interest rates, however, when short-term interest rates are either at, or close to, zero, normal monetary policy can no longer lower interest rates. Quantitative easing may then be used by the monetary authorities to further stimulate the economy by purchasing assets of longer maturity than only short-term government bonds, and thereby lowering longer-term interest rates further out on the yield curve.
Quantitative easing can be used to help ensure inflation does not fall below target. Risks include the policy being more effective than intended in acting against deflation – leading to higher inflation, or of not being effective enough if banks do not lend out the additional reserves.”Quantitative” refers to the fact that a specific quantity of money is being created; “easing” refers to reducing the pressure on banks. However, another explanation is that the name comes from the Japanese-language expression for “stimulatory monetary policy”, which uses the term “easing”. Quantitative easing is sometimes colloquially described as “printing money” although in reality the money is simply created by electronically adding a number to an account. Examples of economies where this policy has been used include Japan during the early 2000s, and the United States and United Kingdom during the global financial crisis of 2008–2009.
Quantitative easing in the US
The US Federal Reserve (“the Fed”) plays an increasingly active role in the performance of the economy and financial markets through the use of its many tools. The most well-known of these tools is its ability to set short-term interest rates, which in turn influences economic trends and the yield levels for bonds of all maturities. The central bank enacts a low-rate policy when it wants to stimulate growth, and it maintains higher rates when it wants to contain inflation. In recent years, however, this approach ran into a problem: the fed effectively cut rates to zero, meaning that it no longer had the ability to stimulate growth through its interest rate policy. This problem prompted the fed to turn to the next weapon in its arsenal: quantitative easing.
In the midst of the 2008 financial crisis, slow growth and high unemployment forced the fed to stimulate the economy through its policy of quantitative easing in the interval from November 25, 2008 through June 2010. The program had little impact initially, so the fed announced an expansion of the program from $600 billion to $1.25 trillion on March 18, 2009.
Immediately after the program wrapped up, trouble emerged in the form of slower growth, the rise of the European debt crisis, and renewed instability in the financial markets. The fed moved in with a second round of quantitative easing, which became known as “QE2” and involved the purchase of $600 billion worth of short-term bonds. This program – which chairman Ben Bernanke first hinted at on august 27, 2010 – ran from November 2010 through June 2011. QE2 sparked a rally in the financial markets but did little to spur sustainable economic growth. As was the case following QE1, the conclusion of QE2 was followed by weak economic data and poor stock market performance. The markets soon began to anticipate a further round of quantitative easing, which was dubbed “QE3.”During the past 20 years, quantitative easing has also been employed by the bank of Japan, the bank of England, and the European central bank.
On September 13, the US Federal Reserve launched its third round of quantitative easing. In addition, the fed officially stated – for the first time – that it would keep short-term rates low through 2015. In contrast to the first two rounds of QE, this round is open-ended – meaning that the Fed can keep pumping money into the system indefinitely. In its statement, the Fed set forth the plan that if the outlook for the labour market does not improve substantially, the committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability. The Fed is buying $85 billion in new assets, including $40 billion in mortgage-backed securities every month until the end of the year.
What differentiates QE3 from QE1 and QE2, is that the commitment is open-ended — the Fed has committed to continuing the buys if the economic situation is not significantly improved at the end of the year. The Fed committee seeks to foster maximum employment and price stability. Without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labour market conditions. Strains in global financial markets continue to pose significant downside risks to the economic outlook. It also anticipates that inflation over the medium term would run at or below its 2 percent objective.
To support a stronger economic recovery and to help ensure that inflation is at the rate most consistent with its dual mandate, the committee agreed to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. It will continue through the end of the year its program to extend the average maturity of its holdings of securities, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. This will increase the committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, and put downward pressure on longer-term interest rates, support mortgage markets, making broader financial conditions more accommodative.
The committee will closely monitor information on economic and financial developments. If the outlook for the labour market does not improve substantially, it will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability. In determining the size, pace, and composition of its asset purchases, the committee will take appropriate account of the likely efficacy and costs of such purchases. To support continued progress toward maximum employment and price stability, the committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. It has decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.
- It helps banks more than the economy, since they can opt to strengthen their balance sheets by “keeping” the money rather than using it to increase their loan activity.
- By creating money, the Fed makes the U.S. dollar less competitive against foreign currencies. (Think supply and demand: a greater supply of dollars, coupled with equal demand, would lead to falling prices; in this case, the “amount” of foreign currency a dollar can buy).
- Increasing the money supply can create Inflation. Since there is a delay between the implementation of Fed policy and the economic impact, inflation may quickly rise to levels that can’t be contained.
- Quantitative easing can create “bubbles” in asset prices as the greater supply of dollars chases the slower-growing supply of goods in the economy. Indeed, the QE policies were followed by sharply rising prices for commodities, driving up prices for consumers.
These critiques have brought together critics such as Ron Paul to protestors at the “Occupy Wall Street” movement, and the calls to “End the Fed” rose in volume in the wake of the QE programs.
Nevertheless, Quantitative Easing has played a major role to help the world recover from the deep recession that followed the financial crisis of 2008 and it remains to be seen if it can work its Magic this time again.
The article is written by Yogesh Athale, SIMSREE, Mumbai