Quantitative easing is designed to stimulate the economy through central bank asset purchases.
- Quantitative easing (QE) is a nontraditional monetary policy in which a central bank buys a large number of securities to stimulate the economy.
- When QE works well, increasing the money supply encourages lending, lowers interest rates and leads to economic growth.
- Critics believe prolonged quantitative easing without growth can cause dramatic inflation, a condition known as stagflation.
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Quantitative Easing (QE) is a type of unconventional monetary policy in which a country's central bank, such as the Federal Reserve, attempts to stimulate the economy by purchasing a large number of long-term securities on the open market to increase the money supply and encourage lending and investment.
"Before the financial crisis, the Fed implemented monetary policy through small daily open market operations to ensure that the federal funds rate traded near its target level," says William English, a professor at the Yale School of Management and former head of the Fed's finance department. "These operations have been small and often temporary. QE is different, affects longer-term yields, and the size of QE operations is much larger."
Assets purchased by the central bank mainly include long-term government bonds and mortgage-backed securities (MBS) issued by Ginnie Mae, Fannie Mae, or Freddie Mac.
How does quantitative easing work?
Using QE to add new money to the economy sets off a powerful chain of events:
- The Fed creates credit. The central bank adds credit (money) to the banking system by building bank reserves on its balance sheet. This is sometimes referred to as "money printing" by the Fed.
- The Fed buys assets. These assets are in the form of long-term government bonds and other financial assets on the open market.
- Demand increases. As the Fed demands more and more of these securities, bond prices rise and the yield (the return on the securities) falls.
- New money (credit) enters the economy. The Fed's purchases bring new cash (in the form of loans) into the accounts of financial institutions, which sell the long-term securities to the government.
- Interest rates fall. This causes lending rates to fall as financial institutions are motivated to lend the extra money they have.
- The economy grows. Businesses and individuals borrow more, invest more, and stock prices rise (since bonds are now a bad investment). The result is a revival of the economy and a reduction in unemployment.
Quick hint: QE is seen as a possible response to a . Viewed Keynesian liquidity trap, named after English economist John Maynard Keynes. A liquidity trap occurs when low interest rates and excess cash fail to stimulate the economy.
Who applied quantitative easing?
Quantitative easing is not only practiced in the U.S. A form of QE was first used between April and July 1932 when the Fed, under pressure from Congress, successfully conducted large-scale open market operations during the Great Depression.
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Quick tip: Although a form of QE was used in the U.S. during the Great Depression, the actual term was first used in Japan in 2001.
Since 2009, the Fed has initiated QE three times in response to the COVID-19 pandemic, in 2010, 2012, and in March 2020. The results of all these efforts give a mixed picture of the effectiveness of quantitative easing.
Is quantitative easing good or bad?
The question remains: Is QE good or bad?? Does it work as advertised? That is, QE flattens the yield curve, increases spending, and promotes economic growth? Empirical evidence is sparse, as quantitative easing has only been used in a few economies. In addition, each of QE's strengths seems to have an Achilles heel.
QE leads to lower interest rates. While this is good for borrowers and investors, it negatively impacts savers and non-investors or those without assets. QE eventually boosts the stock market, but unchecked can lead to runaway inflation. And while it is a reasonably useful tool for GDP growth, QE can also reduce the value of currencies that cause trade problems.
Advantages
Disadvantages
- Encourages borrowing/spending
- Increases stock prices
- Increases economic growth
- Hurts savers and non-investors
- Causes inflation and stagflation
- Lowers the value of the dollar
How quantitative easing affects financial markets?
The impact of quantitative easing on financial markets should be somewhat predictable.
As English puts it, "All other things being equal, QE would be expected to lower longer-term interest rates, boost stock prices and lower the foreign exchange value of the dollar." He notes that these are the same effects, albeit on a larger scale, as traditional Fed funds policy, and says that reducing QE should have the opposite effect – long-term interest rates should rise and stock prices fall.
Anomalies occur, such as the so-called taper tantrum of 2013, when bond prices rose quickly and stocks fell in anticipation of the Fed reducing its quantitative easing policy.
"Markets panicked and interest rates rose in response," says Nicole Tanenbaum, chief investment strategist at Checkers Financial Management. "Investors feared the economy would collapse without the Fed's continued support."
However, when investors realized that the Fed had only announced tapering and ultimately increased its purchases, the market stabilized and avoided a downturn. As with anything to do with the market, perception can easily become reality. This is certainly no less true of QE.
The financial takeaway
Quantitative easing attempts to counter an ailing economy with an infusion of cash. Its design follows the "less is more" model, meaning it should not be extended. The taper tantrum of 2013 shows how investors can become addicted and subject to panic attacks when only the threat of tapering occurs.
Understand the pros and cons of QE and, most importantly, that it is not intended to be permanent. Also know that the jury is still out on QE as an economic remedy. Implemented with care and control, it shows promise but not perfection. Finally, remember that the best economic outcome of quantitative easing is when it is no longer needed.
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