Definition: Often referred to simply as “QE”, it is an attempt by the Federal Reserve Bank (aka “the Fed”) to stimulate the economy by purchasing financial assets (eg: bonds) that banks own. The Fed hopes that the banks will loan some of this new cash out to people and companies who will spend it and cause the economy to grow.Example: On March 18, 2009, just nine days after the stock market plunged to 12-years lows, the Federal Reserve announced that, among other things, it would buy up to $300 billion of longer-term bonds, presumably from banks, over the course of the next six months. The actual press release can be found here.
On November 3, 2010, it announced a second round of QE (aka QE2, not to be confused with the cruise ship) by saying it would purchase up to $600 billion in bonds from that date up through June of 2011. This included a pledge to purchase $75 billion in bonds in November alone. The press release can be found here.
On September 13, 2012, it announced a third round of QE (aka QE-infinity) whereby it would purchase $40 billion worth of bonds per month until the labor and hiring picture improves. The press release can be found here. The amount of monthly purchases as eventually ratcheted up to $85 billion per month before finally being reduced to $0 in October of 2104.
Investeach explains: The Fed has two basic methods or tools for boosting the economy when it is doing badly. It can use its *fiscal policy* power to lower short-term interest rates, making it less costly for people and companies to borrow money and use it to buy goods, grow an existing business, or create a new business.
Sometimes an economy gets so bad that the Fed cuts and cuts interest rates all the way down to zero percent and this still doesn’t help. Rates can’t drop any lower than zero, so there’s nothing more it can do with its fiscal policy power once it has created a “zero interest rate environment”, or ZIRP.
The Fed can turn to its monetary policy power. The theory is that the more money banks have, the more likely they will be to lend it out. It uses quantitative easing to replace bonds banks are holding with cash by purchasing their bonds.
Why is cash better for a bank to have than bonds? Well, a bond represents a loan. A bank that holds one is entitled to receive interest payments a few times a year, and then the amount of the loan when it is due. The loans can be due years from now and the interest rates can be just a few percent. Sure, they will earn some interest and eventually be paid back, but holding loans doesn’t do anything to help banks boost the economy NOW. What the Federal Reserve Bank can do is take hundreds of billions of dollars of bonds off the banks’ hands in exchange for cash, cash which the Fed will encourage the banks to lend! In addition, for reasons that are beyond the scope of our discussion, this also helps drive down long-term interests rates. This also helps the economy because businesses and people can lock in low rates for long term loans.
QE is not without its critics. For one, when interest rates are low, this means they are low not just for borrowers, but for savers who have placed their money in banks and other investments that earn interest. By (banks) paying savers so little, 1% per year or so since the Great Recession ended, we penalize those who have sacrificed to save and who want to see their savings earn a fair amount. This is especially true for retirees who may be trying to live off the interest of a life-time of savings.
Also, by “pumping” made-up dollars into the financial system, it makes each dollar less valuable. In response, inflation may occur for the things we buy that are priced in dollars (ie, pretty much everything). Inflation penalizes all Americans as their money buys less and less than it used to. It deserves mention that some of the increase in prices that occurs is intentional. This keeps the economy out of deflation, a downward spiral in production and prices that itself is also very undesirable.
What else can go wrong with quantitative easing? It simply may not work. Just because banks have more cash on hand doesn’t mean it’ll be lent out. There may be a shortage of credit-worthy borrowers applying for loans. Or, businesses and entrepreneurs, sensing that it’s a poor time to start or grow a business, won’t apply for loans.
Finally, recognize that every business – a bank is a business – is able to produce a report called a Balance Sheet that shows what it owns, what it owes, and what’s left over for its owners. When the Fed buys bonds from banks, it is said to be “expanding its balance sheet”. By the time all of its quantitative easing purchases were complete, the Fed owned over $4 trillion of bonds and other types of debt.
One may wonder where the Fed gets the money to make all these purchases. The answer is that it makes up the money out of thin air. It just says presto, and the money exists. If you are uncomfortable with the idea of the government conjuring up trillions of dollars, you are not alone.
In late 2017 the Fed began to normalize interest rates by raising them. It also announced the beginning of a slow unwinding of QE by selling the bonds it accumulated.
Riddle me this:
1. By what short abbreviation does quantitative easing go?
2. What is the abbreviation we use for the Federal Reserve Bank?
3. What are the two types of tools that the Federal Reserve Bank has for stimulating the economy?
4. Which of the tools or methods has been used to its fullest extent without getting the desired economic recovery?
5. Which type of tool is quantitative easing?
6. Explain how quantitative easing puts banks in a better position to help the economy.
7. Where does the Federal Reserve Bank get the money it uses to purchase bonds from banks?
8. Identify two problems that can occur with quantitative easing.
9. Identify how many years after the last quantitative easing round ended to be sure that the economy is strong enough to withstand an unwinding of the program.