What is quantitative easing?

Posted on Thursday, July 25th, 2019 MarketBeat Staff

Summary - In 2008, the United States Federal Reserve followed the lead of other central banks and launched a program known as quantitative easing (QE). Since the initial program, known as QE1, the United States has gone through additional phases (QE2, QE3, and QE4) that have been credited with accelerating economic activity, particularly the bull market that has existed in the U.S. stock market.

QE stimulates the economy because, by injecting new money into the economy, it makes it easier for businesses to borrow money. In theory, by adding liquidity to the nation’s banks, they would be more likely to lend money to consumers. Quantitative easing keeps interest rates low and decreases the value of the dollar, which makes U.S. exports less expensive and U.S. stocks more attractive to foreign investors.

While traders and investors have enjoyed QE because of the wealth effect it has created (e.g. the prices of U.S. stocks have surged) economists are split on whether QE has accomplished its goals, and if so at what cost? Many question the effect on economic growth that results with so much money being created “out of thin air”. Another question is if our economy is now, in fact, too dependent on the stimulus that came from QE. Questions have also been raised because many banks, instead of lending the extra money they received, actually used the excess reserves to help increase the value of their stocks. This is leading to a wealth disparity as it can be argued that the wealthiest in our society have received the most benefits from QE while being sheltered from many of the harsher consequences.

Introduction

When the private sector economy is functioning properly, money is "created" when banks lend money in the form of loans. The stability of this system is based on the ability of the borrowers to repay the loans. In the early 2000s, a climate of rising housing prices and low-interest rates created an environment where many banks began to approve homeowners for subprime loans despite the borrowers not meeting traditional lending guidelines. Not surprisingly, many of these borrowers began to default on these loans. Banks stopped lending and credit markets began to freeze. Faced with this financial crisis, the Federal Reserve, which had already taken the Federal Funds rate (i.e. the Fed funds rate) down to nearly zero embarked on a new program to inject money into the economy and loosen credit. The program was known as quantitative easing (QE) and while it has seemed to achieve its basic objective, it has created other issues that the U.S. and other central banks will be dealing with for years to come. In this article, we'll review what quantitative easing is, what are its advantages and disadvantages and what questions does QE raise going forward.

What is quantitative easing?

A quantitative easing program is one in which a nation’s central bank uses a supply of newly created money to purchase assets, typically in the form of government bonds, from institutions such as commercial banks, pension funds, and insurance companies. The theory behind QE is that it will facilitate the demand for bonds which will have the effect of lowering the yield on bonds. Also, the institutions that sell their bonds to the Central Bank now have cash that they can use to buy assets that have higher yields. And finally, by increasing the money supply to commercial banks, QE should – in theory – facilitate lending by commercial banks.

Quantitative easing requires the creation of new money

The most controversial part of quantitative easing is the effect it has on a country's monetary supply. In a typical cash transaction, money changes hands, but the actual supply of money in the economy remains unchanged. With QE, a country's Central Bank creates money that did not previously exist. When the United States introduced its initial QE program, QE1, it announced it would purchase $800 billion in bank debt, U.S. Treasury notes and mortgage-backed securities from member banks. The Fed introduced many variations of QE since 2008. As of 2014, the Fed had increased its holdings of securities from $2.1 trillion to $4.5 trillion.

Increasing the money supply has many effects on a nation’s economy.

  1. Wealth Effect – lower interest rates lead to higher stock and bond prices.
  2. Borrowing Effect – lower interest rates reduce the costs of government bonds and mortgages.
  3. Lending Effect – QE increases liquidity which, in theory, should increase lending and help increase consumer spending in the economy.
  4. Currency Effect – As the exchange rate weakens it can make a country’s exports more attractive to foreign countries.

How does quantitative easing work?

In the United States, the Federal Reserve creates money and distributes it into the reserve accounts of the nation's banks. The reserve requirement is the amount of cash that banks must have on hand each night at the close of business. Currently, the Fed puts this requirement at approximately 10% of the deposits that are either held in the bank's vault or the Federal Reserve Bank. In exchange for this cash, the Fed receives mortgage-backed securities and Treasuries. By providing credit (i.e. liquidity) to these banks, the banks now have an excess in reserves. Banks can then make a profit from this excess by lending this money to other banks.

What are the advantages of quantitative easing?

If you support an activist central bank then one of the advantages of quantitative easing is that it gives central bankers an extra tool to help shape monetary policy. Another advantage of pumping money into the economy is that it promotes price stability by helping to lower any threat of price deflation. In theory, lowering interest rates raises business confidence and promotes economic activity in the form of borrowing. This is due, in part, to the fact that QE provides commercial banks with more assets to lend to businesses and consumers. Yet another advantage to quantitative easing is that, because it depresses a country’s exchange rate it can make a country’s export industries more price competitive.

What are the disadvantages of quantitative easing?

Rising asset prices tend to benefit those that were already in the position to buy them in the first place. This is particularly true in the case of home prices and even rent. If home prices are rising, it may become difficult for many prospective buyers to buy them even though interest rates are lower. Also, by tamping down threats of deflation, quantitative easing raises inflationary pressures. Another disadvantage is that when interest rates remain very low it creates a distorting in how capital is allocated. This is manifest in “zombie” companies that only exist because of their ability to refinance debt at lower interest rates. Finally, quantitative easing decreases the annual income that pension recipients may receive. Because interest rates are so low, it creates an environment that is not favorable for those on a fixed income.

The larger questions raised by quantitative easing

Did quantitative easing work? The answer is a qualified yes. It did help banks clear subprime mortgages from their balance sheets, it stabilized the economy by providing adequate liquidity for businesses, and it kept interest rates low so the housing market could be revived after so many homes went into foreclosure. However, one of the unintended consequences was that many banks – instead of increasing lending – held onto the cash. This helped the banking sector as many banks saw their stock prices soar through dividends and stock buybacks. However, because the banks did not lend the money, the inflation that the Fed expected did not arrive and in its place, a series of new asset bubbles have formed.

For the foreseeable future, QE will force the United States to address questions that other countries, like Japan, have been addressing since they started their version of quantitative easing in 2001.

  1. What has been the actual impact of QE on the real economy?
  2. What other problems are created when the Central Bank becomes a major holder of a country’s debt?
  3. Could QE be expanded, or redirected, to help achieve different objectives (e.g. Infrastructure, health care, or environmental funding)?
  4. Does QE make an economy too dependent on cheap money?

The bottom line on quantitative easing

Quantitative easing (or QE) is a fiscal policy that a nation’s Central Bank can take as part of their open market operations. The purpose of a QE program is to inject liquidity into a nation’s capital markets. To accomplish this, the Central Bank purchases securities, usually treasury bills and government bonds, from its member banks. The premise behind QE is that as bank deposits increase they will be more inclined to lend money to businesses and consumers, which will spur further economic growth. In the United States, the Federal Reserve first instituted QE in response to the financial crisis in 2008. Quantitative easing is a controversial program because it is very difficult to assess to what extent the program affected the real economy. What is more obvious is the increase in the money supply which also means the central bank is now holding a large portion of our nation’s debt.

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