Explaining Quantitative Easing – QE

Cartoon of Quantitative Easing as a medicine with dollar signs dripping into a spoon and the words
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Quantitative easing (QE) is an expansion of the open market operations of a country's central bank. In the United States, the Federal Reserve is the central bank.

QE is used to stimulate an economy by making it easier for businesses to borrow money. Under QE methods, the central bank will buy mortgage-backed securities and Treasurys from its member banks which causes an added liquidity in the flow of money in capital markets. The asset purchases are done by the trading desk at the New York Federal Reserve Bank. 

No funds change hands but the central bank issues a credit to the banks' reserves as it buys the securities. QE has the same effect as increasing the money supply

The purpose of this type of expansionary monetary policy is to lower interest rates and spur economic growth.

Money Supply Domino Effect

Where do central banks get the funds to purchase these assets? They simply create it out of thin air. This is what financial media speaks of when they refer to the Federal Reserve printing money. In the United States, only the central bank has this unique power.

The greater the supply of money in an economy, the lower the corresponding interest rates are. In turn, lower rates allow banks to make more loans. Increased lending stimulates demand by giving businesses money to expand and individuals money to buy things like homes, cars, and boats.

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 U.S. exports less expensive.

The Historic Use of QE

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. In December 2018, it announced it would end the program.

QE and Bank Reserve Requirements

The bank reserve requirement is the value of funds that banks must have on hand each night when they close their books. The Fed requires that banks hold around 10% 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.

The total value of Treasurys held by the Fed vary, In March 2009 that value was $492.3 million. By July 2019 that number had mushroomed to $2.095 trillion.

QE1: December 2008 - June 2010

At the November 25, 2008, Federal Open Market Committee meeting, the Fed announced QE1. It would purchase $800 billion in bank debt, U.S. Treasury notes, and mortgage-backed securities from member banks. 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.

Its other monetary policy tools were also maxed out. The discount rate was near zero. The Fed even paid interest on banks' reserves. 

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 terminated QE1 in March 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 its purchases with QE2. It would buy $600 billion of Treasury securities by the end of the second quarter of 2011. The Fed also shifted its focus to inducing mild inflation, gradually enough to spur demand.

Although QE2 succeeded in keeping rates low, it didn’t encourage banks to lend more. The volume of money in circulation didn’t increase. Banks were still too edgy to lend out after the recession. They simply saved up their extra credit.

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 - December 2012

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:

  1. Announced it would keep the fed funds rate at zero until 2015.
  2. Said it would keep purchasing securities until jobs improved "substantially."
  3. Acted to boost the economy, not just avoid a contraction.

QE4: January 2013 - October 2014

In December 2012, the Fed announced QE4, effectively ending QE3. It intended to buy a total of $85 billion in long-term Treasurys and MBS. It ended Operation Twist, instead of 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% or inflation would rise above 2.5%.

Some experts consider QE4 as just an extension of 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 this 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. 

  1. The unemployment rate was at 7%. 
  2. Gross domestic product growth was between 2% and 3%.
  3. The core inflation rate hadn't exceeded 2%.

The FOMC would keep the fed funds rate and the discount rate between zero and one-quarter points until 2015 and below 2% through 2016. 

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 worth 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. It began reducing its holdings in October 2017.

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, consequently, 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 the interest rates low enough to revive the housing market.

Instead of inflation, QE created a series of asset bubbles.

Fourth, it stimulated economic growth, although probably not as much as the Fed would have liked. It didn't achieve the Fed's goal of making more credit available. It gave the money to banks, but the banks 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% of banks control more than 70% of bank assets.

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 Consumer Price Index, stayed below the Fed's 2% target.