What is it basically?
An “expansionary monetary policy”: that is, a policy that attempts to increase the size of the money supply, typically with the goal of lowering interest rates. Lower interest rates encourage (1) investors to look for higher yield places to park their money (e.g. riskier investments, such as stocks) and (2) borrowers to borrow (because money is so cheap). These twin side effects are intended to stimulate the economy.
As discussed elsewhere, the Fed controls some set of interest rates (e.g. the federal funds target rate); many other (private sector) interest rates are pegged to those controlled by the Fed. In particular, the US Prime Rate is typically (since 1994) three percentage points above the federal funds target rate. The US Prime Rate “is used by many banks to set rates on many consumer loan products, such as student loans, home equity lines of credit, car loans and credit cards.”
There are some interest rates, however, that are not directly related to the federal funds target rate (or are more loosely correlated) and so if the Fed wishes to lower these rates, they have to use different tactics. Applying quantitative easing – targeted toward purchasing private sector assets (e.g. bank bonds) – is one such technique.
How do you do it?
The central bank (e.g. the Federal Reserve) buys assets (e.g. US Treasury Securities) from the government or from the private sector (insurance companies, pension funds, banks, non-financial firms) by crediting the account of the seller (e.g. the private bank’s federal reserves account). In this way, the central bank didn’t literally print more money but it did in effect create money out of thin air by exercising its ability to credit one account without debiting another. Not only does this inject more money into the economy but it also frees up the seller to redeploy that capital elsewhere (for example, lending it to other institutions or to consumers).
- “The Bank can create new money electronically by increasing the balance on a reserve account. So when the Bank purchases an asset from a bank, for example, it simply credits that bank’s reserve account with the additional funds.” Source: The Bank of England: Quantitative Easing
- See also: Understanding The Federal Reserve Balance Sheet
- What’s a federal reserves account?
- Insert link here, when new section on federal reserves accounts is done.
- E.g. recent US quantitative easing
- In 2008, the Fed doubled its holdings of US Treasury securities – from approx $750B (in 2007) to approx $1.5T (in June 2011), now $1.7T.
- This included $600B in Mortgage Backed Securities (MBSs) (presumably from Freddie Mae and Fannie Mac). It also bought bank debt and treasury notes.
- In 2010, the Fed bought another $600B in Treasury Securities; this was referred to as QE2.
Why do you do it?
Lowering interest rates is one of the key tricks for stimulating the economy (as described here). If interest rates are already sufficiently low OR if lenders still don’t want to loan money, then central banks (e.g. the Fed) do QE in order to lower interest rates that are not otherwise under the control of the central bank (e.g. interest rates of securities that are not pegged to the rate of US Treasury securities).
- However, “economists [have] warned that quantitative easing may be of limited use when the problem is a lack of demand, rather than of liquidity — that consumers and businesses were uninterested in spending in the face of high unemployment no matter how much cheap money is around.” Source: Times Topics: Quantitative Easing
- “The cost of borrowing is not the problem,” said Paul Ashworth, chief United States economist at Capital Economics. “The problem is that there are not creditworthy borrowers, and that businesses don’t want to invest because they’re concerned about the economic outlook.” Source: Nearly Out of Tricks, Fed May Pare Longer Rates