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What is Quantitative Easing?

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What is Quantitative Easing?

What is Quantitative Easing, or QE? The answer to that question can vary depending on who you ask. Strictly speaking, Quantitative Easing is a relatively new monetary policy in which a central bank purchases a specified amount of financial assets from the balance sheets of financial institutions, such as commercial banks and mortgage lenders. The overarching objective of QE is to provide liquidity to the financial market, in order to facilitate increased lending between financial institutions and businesses, as well as consumers. This works by raising the demand for those financial assets, which leads to an increase in their price and causes a decrease in their yield (or interest rate). At the same time it also expands the monetary base, or supply of money within the economy.

Typically, when the central bank wishes to take actions that will lower interest rates, it will purchase short-term government bonds. This causes a decrease in interest rates paid between financial institutions themselves, which indirectly decreases the interest rates between financial institutions, businesses and consumers. By contrast, quantitative easing lowers interest rates paid by businesses and consumers in a more direct way by purchasing financial assets directly from commercial banks and mortgage lenders themselves.

As an analogy, imagine that the central bank is a doctor and the economy is his patient. The economy gets sick when interest rates are too high, causing lending to decrease, making the economy become sluggish. To fight the high interest rates, the central bank gives the economy an increase in the money supply, or antibiotic. Usually, if a doctor prescribes you an antibiotic, he will give you a pill to take. That pill is absorbed into your body through your stomach and slowly diffuses to where it is needed. This is an indirect way of fighting the illness (high interest rates). However, if the doctor feels that it's necessary to take a more direct approach to curing your ailments (high interest rates), he might decide to give you an injection directly at the site of the infection. This circumvents the process of being absorbed by your stomach and slowly diffusing to the site of the infection. In this analogy, the pill is the central bank purchasing bonds from the government to decrease interest rates between financial institutions (which indirectly lowers interest rates for consumer and businesses), and quantitative easing is the injection (which directly lowers interest rates for businesses and consumers).

Why Do We Need QE?

In 2008, the financial system in the United States came to a screeching halt, which caused the global financial markets to do the same. Ultimately, the reason this occurred was because banks and mortgage lenders were making unstable loans to subprime (unqualified) borrowers in mass amounts, bundling those loans together as financial assets, and then selling those assets to investors. The reason people were willing to buy these assets was due to the fact that they were given high credit ratings by the 3 largest credit rating agencies: Moody's, S&P, and Fitch. As those subprime (unqualified) borrowers started to default on their loans, the value of the assets that were derived from those loans started to dramatically decrease. This caused the risk profile of those assets to increase, and the interest rates that people demanded in return for purchasing them to increase as well. Eventually, these financial products became known as “toxic assets” because investors were so averse to buying them.

The practice of sub prime lending occurred for such a long period of time, and on such a massive scale, that the entire financial system within the United States froze; causing one of the largest one day stock market losses in history. Many of the largest investment firms quickly became insolvent, and were at risk of total financial failure. In 2008, two of the oldest and largest investment banks, Bear Stearns and Lehman Brothers, failed. Emergency actions such as TARP (the bailout) were taken to prevent the financial system from  completely collapsing.

After the financial system was stabilized, the economy was still in a fragile state due to low economic activity. This was because many of the largest financial institutions still had trillions of dollars worth of toxic assets remaining on their balance sheets, which prohibited them from lending. Despite the Federal Reserve lowering the interbanking interest rate (the pill from our analogy above) to zero percent, many banks were still handcuffed from lending because they were so laden with toxic assets. Ergo, a more direct approach was needed to free up lending between commercial banks, businesses and consumers. Which is why Quantitative Easing (the injection from our above analogy) was introduced in 2009.

How Long Will It Go On? How Long Will It Be?

Since 2009, there have been three phases of Quantitative Easing which have been labeled QE1, QE2, and QE3. Each phase has grown successively larger because of the sheer size and systemic nature of the problem.

The first phase, QE1, ran from November of 2008 until June of 2010. During that period, the Federal Reserve added approximately 1.4 trillion dollars worth of toxic mortgage backed securities, bank debt, and treasury bills to their balance sheets. The total amount of securities held by the Federal Reserve at that point was 2.1 trillion dollars.. By the end of June of that year, the Federal Reserve halted it’s buying program because of marked improvement in the economy.

In November, quantitative easing measures were again resumed because the economy had once again come to a stand still. QE2, lasted from November of 2010 until June of 2011. During that period the Federal Reserve added another 600 billion dollars in mortgage backed securities to it’s balance sheets over the seven month period.

In September of 2012, the Federal Reserve once again resumed quantitative easing measures. However, under what is known as QE3, the program has been instituted on an indefinite basis. Initially, the Federal Reserve was to buy $40 billion per month of bad assets from banks, but in December of 2012, that amount was increased to $85 billion per month. In December of 2013, the Fed announced that it would be tapering back QE3 by $10 billion per month, down to $75 billion. The Fed then tapered the program again in January and March by the same amount, bringing the total monthly asset purchases to $55 billion per month.

 Is Quantitative Easing the Same Thing As Inflation?

Not exactly. Inflation has been pretty steady since the Financial Crisis of 2008, averaging just under 2% per year, according to the CPI. The biggest areas of the economy that have seen inflation have been food and energy costs. However, the relative inflation of the price of food and energy has still been much smaller than in past periods of high inflation, such as the period following the the Savings and Loan crisis in the late 80’s and early 90’s, and during the oil embargo of the 1970’s

Yes, the Federal Reserve has inserted a historically large amount of money into the financial system over the past 6 ½ years by any measure, relative or not. The difference, at least up until this point, is that the vast majority of that money has stayed on the balance sheets of commercial banking institutions, and has not entered into circulation. In economics, money is “created” when commercial banks and mortgage lenders loan money out that can then be circulated within the economy. Historically, the Federal Reserve has been known to use their power to issue new money to pay off portions of government debt from time to time, this is known as monetizing the debt. Monetizing the debt does have an immediate inflationary effect because the money is then released into circulation to the holders of government debt, and can then be used to purchase goods and services. However, the money that has been issued for quantitative easing has not entered circulation as of yet. Inflation only occurs when money is created, AND put into circulation.

If you think about it for a moment, it makes sense; because the economy has been so stagnant over the last 6 years, banks have been hesitant to loan money out except to only the most qualified borrowers. For a high level of inflation to occur, money would need to be lent out at rates similar to, or higher than, those that were seen during the housing boom. However, this brings up a good question. Could inflation start to increase dramatically if, and when, the economy starts recovering in a real and robust way. Yes, that is completely possible. If the economy were to start growing rapidly and the banks started lending out the trillions of dollars they have on their balance sheets (from the Fed’s asset buying program) at a rate that outpaced the growth in real goods and services, we would most certainly see higher rates of inflation.

The truth is, that nobody really knows at this point how the policy of quantitative easing is going to play out over the next decade or so. Quantitative easing has never been done before, so there’s no real precedent to measure the long term effects of the policy. Speculation that a period of hyperinflation is imminent, is just as naive as an absolute certainty that high inflation will not occur. The best advice that anyone can give, when it comes to the future prospects of inflation, is to be financially prepared for either scenario.

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