The Federal Reserve employs quantitative easing to stimulate the economy during times of crisis. It expands the money supply while lowering long-term interest rates.
What Is QE (Quantitative Easing)?
A central bank purchases long-term securities from its member banks, known as quantitative easing (QE). The central bank injects new money into the economy by purchasing these securities; as a result of the influx, rates of interest fall, making it easier for people to finance. QE is a monetary policy tool that expands the Fed's open market operations, influencing the money supply. Lowering interest rates is another tool; the Fed employs QE after lowering the Fed funds rate to zero. (All other short-term rates are based on the Fed funds rate.)Important Takeaways:
- Quantitative easing is the practice of a central bank purchasing long-term securities to stimulate the economy.
- QE increases the money supply and stimulates economic growth.
- The Fed in 2008 used it to combat the financial crisis.
- It reactivated QE to combat the COVID-19 pandemic.
What is Quantitative Easing?
When the Federal Reserve purchases securities from its member banks, it exchanges cash for assets such as bonds. Can then lend out the extra money. The Fed also regulates banks' reserve requirements, which govern how much of their funds they must keep on hand compared to what they lend out. Lowering the reserve allows banks to lend out more of their funds. More money being spent expands the supply of money, allowing interest rates to fall. Lower interest rates encourage people to borrow and spend, stimulating the economy.Important:
Any deposits that exceed a bank's reserves are lent. These loans are then transferred to other banks. They only keep 10% in reserve and lend the rest. That is how a trillion dollars in Fed credit can result in a trillion dollars in economic growth. Following the 2008 financial crisis, the Fed used quantitative easing to restore financial market stability. In 2020, in response to the financial fallout from the COVID-19 pandemic, the Fed resorted to QE, increasing its balance sheet to $7 trillion.Other Ways QE Helps the Economy
In addition, quantitative easing stimulates economic growth in three ways.Bond yields are kept low by QE.
The federal government auctions off large amounts of Treasurys to fund expansionary fiscal policy. The Fed's purchases of Treasurys increase demand, keeping Treasury yields minimal (with bonds, there is an inverse relationship between yields and prices). Treasury bonds serve as the foundation for all long-term interest rates. As a result, quantitative easing through Treasury purchases keeps auto, furniture, and other consumer debt rates low. The same can be said of long-term, fixed-interest debt. Low-interest rates on corporate bonds make it possible for businesses to grow when mortgage rates remain low, and the housing market benefits.QE encourages foreign investment and boosts exports.
Increasing the money supply also keeps the country's currency's value low. Foreign investors prefer US stocks when the dollar is weaker because they can get more for their money. It also reduces the cost of exports.QE May Cause Inflation
The only disadvantage of QE is that it raises the Fed's holdings of Treasury bonds and other securities. Before the 2008 financial crisis, the Fed's balance sheet was less than $1 trillion. By July 2014, the figure had risen to nearly $4.5 trillion. The more money the Fed prints, the less valuable existing money becomes. This lowers the value of all dollars over time, causing them to buy less. As a result, inflation occurs. Inflation does not occur until the economy is doing well. When that happens, the Fed's assets increase as well. The Fed would have no hesitation in selling them. Selling assets would reduce the money supply and dampen any inflationary pressures.QE All Over the World
From 2001 to 2006, Japan was the first country to use QE. It resumed in 2012, with Shinzo Abe's election as Prime Minister. With his three-pronged "Abenomics" program, he promised economic reforms for Japan. After seven years of austerity, the European Central Bank implemented QE in January 2015. It agreed to buy 60 billion euros in euro-denominated bonds, lowering the euro's value and increasing exports. It increased monthly purchases to 80 billion euros. It announced in December 2016 that it would reduce its purchases to 60 billion euros per month beginning in April 2017. Terminated the program in December 2018.In the United States, QE is used.
To combat the financial crisis, the Fed initiated four rounds of QE in 2008. They were in effect from December 2008 to October 2014. The Fed used QE because its other tools for expanding monetary policy had reached their limits. The Fed funds and discount rates were both zero. The Fed even started paying banks interest on their reserve requirements. As a result, quantitative easing became the primary tool used by the central bank to alleviate the crisis. QE increased the money supply and the Fed's balance sheet by nearly $4 trillion. From less than $1 trillion in November 2008 to $4.4 trillion in October 2014, the Fed's balance sheet more than doubled. It was the most significant expansion of any economic stimulus program until 2020.QE1 runs from December 2008 to June 2010.
The Federal Open Market Committee (FOMC) announced QE1 on November 25, 2008. It plans to buy $600 billion in bank debt, Treasury notes, and mortgage-backed securities (MBS) from member banks. The Fed had purchased $1.25 trillion in MBS by February 24, 2010. It also purchased $700 billion in longer-term Treasury securities, such as 10-year notes. Important: Some experts feared that the massive amount of toxic loans on the Fed's books would bankrupt it, but the Fed can create cash to cover any toxic debt. Furthermore, it could keep the debt until the housing market recovered.QE2 runs from November 2010 to June 2011.
On November 3, 2010, the Fed announced it would increase its purchases through QE2. By the end of the second quarter of 2011, it planned to purchase $600 billion in Treasury securities. This would keep the Fed's holdings at the $2 trillion mark. Some investors were concerned that QE would cause hyperinflation and began purchasing Treasury Inflation-Protected Securities. Others began purchasing gold as a standard inflation hedge. This caused gold prices to skyrocket, reaching a record high of $1,917.90 per ounce in August 2011.Twist Operation: September 2011 to December 2012
The Federal Reserve launched "Operation Twist" in September 2011. With two exceptions, this was similar to QE2. First, as short-term Treasury bills matured, the Fed purchased long-term notes. Second, the Fed increased its MBS purchases. Both "twists" were intended to help the slowing housing market.QE3 runs from September to December 2012.
The Fed announced QE3 on September 13, 2012. It agreed to purchase $40 billion in MBS and continue Operation Twist, adding $85 billion in monthly liquidity. The Fed also did three things that it had never done before:- It announced that the Fed funds rate would remain at zero until 2015.
- It stated that it would continue to buy securities until employment improved "substantially."
- Acted to stimulate the economy rather than avoid a recession17
QE4 runs from January 2013 to October 2014.
The Fed announced QE4 in December 2012, effectively ending QE3. It planned to purchase $85 billion in long-term Treasurys and MBS. Instead of simply rolling over the short-term bills, it ended Operation Twist. It clarified its position by promising to continue purchasing securities until one of two conditions was met: unemployment fell below 6.5 percent or inflation rose above 2.5 percent. Some experts thought QE4 was simply an extension of QE3. Others dubbed it "QE Infinity" because it had no set end date. QE4 enabled cheaper loans, lower mortgage rates, and a devalued dollar.2008-2014: The End of QE
The FOMC announced on December 18, 2013, that it would begin tapering its purchases as it met its three economic targets:- The unemployment rate was 7.5%.
- Gross domestic product growth ranged between 2% and 3%.
- The core inflation rate had not risen above 2%.
QE 2020
QE was most recently used in response to the COVID-19 pandemic. The Federal Reserve announced on March 15, 2020, that it would purchase $500 billion in US Treasury bonds. It plans to purchase $200 billion in mortgage-backed securities over the next few months.Quantitative Easing Was Effective
QE achieved some of its objectives while failing to achieve others and causing several asset bubbles. To begin, it removed toxic subprime mortgages from bank balance sheets, restoring trust and, as a result, banking operations. Second, it aided in the stabilization of the US economy by providing the funds and confidence needed to exit the recession. Third, it kept interest rates low enough to help the housing market recover. That is why QE1 reduced interest rates by nearly a whole percentage point. Fourth, it boosted economic growth, albeit not as much as the Fed would have liked. It gave the money to banks, but the banks kept it. Banks used the funds to triple their stock prices through dividends and stock buybacks instead of lending them out. QE did not result in widespread inflation, as many had predicted. However, making money so cheap caused asset bubbles. An asset bubble is defined as a significant increase in the price of an asset, such as housing, the asset's underlying value does not support that. For example, the housing bubble fueled by QE caused home prices to skyrocket, but the rising prices were disconnected from the homes' actual values.Frequently Asked Questions(FAQs)
When did quantitative easing get started?
Japan implemented quantitative easing as part of "Abenomics" in 2001. The Bank of Japan established a 2% inflation target and purchased assets to achieve it until 2006.What effect does quantitative easing have on bond yields?
Bond yields fall as a result of quantitative easing. Quantitative easing raises bond prices while lowering bond yields by leveraging the purchasing power of an entire government. Bond yields fall as bond prices rise. 28 When there are more buyers than sellers, the supply-demand balance shifts, and prices rise.