What is Quantitative Easing?

The Basics of Quantitative Easing

The U.S. 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.
What is Quantitative Easing?
The Fed, or any central bank for that matter, enacts quantitative easing by creating money
and then buying bonds or other financial assets from banks. The banks then will have more
cash available to loan. Higher loan growth, in turn, should make it easier to finance projects
for example, the construction of a new office building. These projects put people to work,
thereby helping the economy to grow. In addition, the Feds purchases help drive up the
prices of bonds by reducing their supply, which causes their yields to fall. Lower yields, in
turn, provide the fuel for economic expansion by lowering borrowers costs.
This is how the idea works on paper, at least. In practice, banks dont have to loan excess
cash. If banks are tentative and lacking in confidence as was the case in the years following
the financial crisis of 2008 the higher money supply may not prove to be the engine of
growth the Fed had in mind.
QE1 and "QE2
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.
QE3 Launched in September 2012
On September 13, 2012, the U.S. 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. These moves reflect the Fed's view that the economy still hasn't
reached the point of self-sustaining growth (in other words, the ability to keep growing
without stimulus). Accordingly, the Fed has adopted what has been called "QE Infinity," a
plan to purchase $85 billion of fixed-income securities per month, $40 billion of mortgage-
backed securities and $45 billion of U.S. Treasuries. Unlike QE1 and QE2, the current
program has no set end date. However, the consensus is that the Fed will begin to wind down
the size of its purchases before 2013 is over, with the goal of ending the program by 2015. At
the time present, QE is fluid and subject to change based on economic conditions.
The Case Against Quantitative Easing
The Feds various QE programs have led to sharp criticism from across the political
spectrum. Among the arguments against quantitative easing are:
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 a 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 cant be contained.
Quantitative easing can create bubbles in asset prices.