Quantitative Easing Explained
How Central Banks Create Massive Amounts of Money
Quantitative easing is a massive expansion of the open market operations of a central bank. It’s used to stimulate the economy by making it easier for businesses to borrow money. The bank buys securities from its member banks to add liquidity to capital markets. This has the same effect as increasing the money supply. In return, the central bank issues credit to the banks' reserves to buy the securities.
Where do central banks get the credit to purchase these assets? They simply create it out of thin air. Only central banks have this unique power. This is what people are referring to when they talk about the Federal Reserve “printing money.”
The purpose of this type of expansionary monetary policy is to lower interest rates and spur economic growth. Lower interest rates allow banks to make more loans. Bank loans stimulate demand by giving businesses money to expand. They give shoppers credit to purchase more goods and services.
By increasing the money supply, QE keeps the value of the country's currency low. This makes the country's stocks more attractive to foreign investors. It also makes exports cheaper.
Japan was the first to use QE, from 2001 to 2006. It restarted in 2012, with the election of Shinzo Abe as Prime Minister. He promised reforms for Japan's economy with his three-arrow program, “Abenomics.”
The U.S. Federal Reserve undertook the most successful QE effort. It added almost $2 trillion to the money supply. That’s the largest expansion from any economic stimulus program in history. As a result, the debt on the Fed’s balance sheet doubled from $2.106 trillion in November 2008 to $4.486 trillion in October 2014.
The European Central Bank adopted QE in January 2015, after seven years of austerity measures. It agreed to purchase 60 billion in euro-denominated bonds, lowering the value of the euro and increasing exports. It increased those purchases to 80 billion euros a month. In December 2016, it announced it would taper its purchases to 60 billion euros a month in April 2017. The euro to dollar conversion shows how the euro is faring against the U.S. dollar.
Quantitative Easing Explained
How does quantitative easing work? The Fed adds credit to the banks' reserve accounts in exchange for mortgage-backed securities and Treasurys. The asset purchases are done by the trading desk at the New York Federal Reserve Bank.
The reserve requirement is the amount that banks must have on hand each night when they close their books. The Fed requires that banks hold around 10 percent of deposits either in cash in the banks' vaults or at the local Federal Reserve bank.
When the Fed adds credit, it gives the banks more than they need in reserves. Banks then seek to make a profit by lending the excess to other banks. The Fed also lowered the interest rate banks charge. This is known as the fed funds rate. It is the basis for all other interest rates.
Quantitative easing also stimulates the economy in another way. The federal government auctions off large quantities of Treasurys to pay for expansionary fiscal policy. As the Fed buys Treasurys, it increases demand, keeping Treasury yields low. Since Treasurys are the basis for all long-term interest rates, it also keeps auto, furniture and other consumer debt rates affordable. The same is true for corporate bonds, making it cheaper for businesses to expand. Most important, it keeps long-term, fixed-interest mortgage rates low. That's important to support the housing market.
QE1: December 2008 - June 2010
The Fed started quantitative easing to combat the financial crisis of 2008. It had already dramatically lowered the fed funds rate to effectively zero. The current fed interest rates are always an important indicator of the nation’s economic direction.
By 2010, the Fed bought $175 million in MBS that had been originated by Fannie Mae, Freddie Mac, or the Federal Home Loan Banks. It also bought $1.25 trillion in MBS that had been guaranteed by the mortgage giants. Initially, the purpose was to help banks by taking these subprime MBS off of their balance sheets. In less than six months, this aggressive purchasing program had more than doubled the central bank's holdings. Between March and October 2009, the Fed also bought $300 billion of longer-term Treasurys, such as 10-year notes.
The Fed halted purchases in June 2010 because the economy was growing again. Just two months later, the economy started to falter, so the Fed renewed the program. It bought $30 billion a month in longer-term Treasurys to keep its holdings at around $2 trillion. Although there were some shortcomings, QE1 was successful enough in helping prop up the fallen housing market with low interest rates.
QE2: November 2010 - June 2011
On November 3, 2010, the Fed announced it would increase quantitative easing, buying $600 billion of Treasury securities by the end of the second quarter of 2011. The Federal Reserve's quantitative easing 2 shifted its focus to inducing mild inflation, gradual enough to spur demand.
Operation Twist: September 2011 - December 2012
In September 2011, the Fed launched Operation Twist. This was similar to QE2, with two exceptions. First, as the Fed's short-term Treasury bills expired, it bought long-term notes. Second, the Fed stepped up its purchases of MBS. Both "twists" were designed to support the sluggish housing market.
QE3: September 2012 - October 2014
On September 13, 2012, the Fed announced QE3. It agreed to buy $40 billion in MBS and continue Operation Twist, adding a total $85 billion of liquidity a month. The Fed did three other things it had never done before:
- Announced it would keep the fed funds rate at zero until 2015.
- Said it would keep purchasing securities until jobs improved "substantially."
- Acted to boost the economy, not just avoid a contraction.
QE4: January 2013 - October 2014
In December 2012, the Fed announced it would buy a total of $85 billion in long-term Treasurys and MBS. It ended Operation Twist, instead just rolling over the short-term bills. It clarified its direction by promising to keep purchasing securities until one of two conditions were met. Either unemployment would fall below 6.5 percent or inflation would rise above 2.5 percent. Since QE4 is really just an extension of QE3, some people still refer to it as QE3. Others call it "QE Infinity" because it didn't have a definite end date. QE4 allowed for cheaper loans, lower housing rates, and a devalued dollar, all of which spurred demand and as a consequence, employment.
The End of QE
On December 18, 2013, the FOMC announced it would begin tapering its purchases, as its three economic targets were being met.
- The unemployment rate was at 7 percent.
- GDP growth was between 2 and 3 percent.
- The core inflation rate hadn't exceeded 2 percent.
Sure enough, on October 29, 2014, the FOMC announced it had made its final purchase. Its holdings of securities had doubled from $2.1 trillion to $4.5 trillion. It would continue to replace these securities as they came due to maintain its holdings at those levels.
On June 14, 2017, the FOMC announced how it will begin reducing its QE holdings. It will allow $6 billion of Treasurys to mature each month without replacing them. Each following month it will allow another $6 billion to mature until it has retired $30 billion a month. The Fed will follow a similar process with its holdings of mortgage-backed securities. It will retire an additional $4 billion a month until it reaches a plateau of $20 billion a month being retired. This change won't occur until the fed funds rate reaches 2 percent.
Quantitative Easing Worked
QE achieved some of its goals, missed others completely and created several asset bubbles. First, it removed toxic subprime mortgages from banks' balance sheets, restoring trust and therefore banking operations. Second, it helped to stabilize the U.S. economy, providing the funds and the confidence to pull out of the recession. Third, it kept interest rates low enough to revive the housing market.
Fourth, it stimulated economic growth, although probably not as much as the Fed would have liked. That's because it didn't achieve the Fed's goal of making more credit available. It gave the money to banks, but they sat on the funds instead of lending them out. Banks used the funds to triple their stock prices through dividends and stock buybacks. In 2009, they had their most profitable year ever.
The large banks also consolidated their holdings. Now, the largest 0.2 percent of banks control more than 70 percent of bank assets.
That's why QE didn't cause widespread inflation, as many had feared. If banks had lent out the money, businesses would have increased operations and hired more workers. This would have fueled demand, driving up prices. Since that didn't happen, the Fed's measurement of inflation, the core CPI, stayed below the Fed's 2 percent target.
Instead of inflation, QE created a series of asset bubbles. In 2011, commodities traders turned to gold, driving its price per ounce from $869.75 in 2008 to $1,895.
In 2012, investors turned to U.S. Treasurys, driving the yield on the 10-year note to a 200-year low.
In 2013, investors fled out of Treasurys and into the stock market, driving the Dow up 24 percent. This followed Ben Bernanke's announcement on June 19 that the Fed was considering tapering. That threw bond investors into a panicked selling spree. As demand for bonds fell, interest rates spiked 75 percent in three months. As a result, the Fed held off the actual taper until December, giving the markets a chance to calm down.
In 2014 and 2015, the value of the dollar rose 25 percent, as investors created an asset bubble in U.S. dollars. This is the opposite of what's supposed to happen with QE. But the U.S. dollar is a global currency and a safe haven. Investors flock to it despite high supply, making this one area that turned okay despite the QE not working as intended.
The Fed did what it was supposed to do. It created credit for the financial markets when liquidity was severely constrained. But it couldn't overcome contractionary fiscal policy. Between 2010 and 2014, Tea Party Republicans gained control of the House of Representatives. They insisted on budget cuts when the economy was not yet on its feet. They threatened to default on the national debt in 2011. They also initiated a 10 percent spending sequester. They created a government shutdown in 2013.
The Fed also could not force banks to lend. Its strategy of adding money to the system was like pushing a string. It created bubbles in other asset classes without getting needed funds to households and businesses.