Explaining Quantitative Easing – QE
How It Allows Central Banks to Create Massive Amounts of Money
Quantitative easing (QE) is when a central bank buys long-term securities from its member banks. In return, it issues credit to the banks' reserves.
Where do central banks get the funds to purchase the banks' securities? They simply create them out of thin air. In the United States, only the Federal Reserve has this unique power. That's why some people say the Federal Reserve is printing money.
QE increases the money supply. It lowers long-term interest rates, makes it easier for banks to lend, and spurs economic growth.
QE is an expansion of the Fed's open market operations. The Fed uses QE after it's lowered the fed funds rate to zero. This rate is the basis for all other short-term rates. In the United States, the QE purchases are done by the trading desk at the New York Federal Reserve Bank.
- Quantitative easing is when a central bank purchases member banks' securities.
- It uses credit it creates out of thin air.
- QE expands the money supply and stimulates growth.
- The Fed used it to combat the 2008 financial crisis.
- It revived QE to respond to the COVID-19 pandemic.
How QE Works
When the Fed adds credit to a bank's balance sheet, it gives it more than it needs to meet the reserve requirement. The reserve is the amount the Fed requires banks to have on hand each night when they close their books.
On March 15, 2020, the Fed announced it had reduced the reserve requirement ratio to zero effective March 26, 2020. It did so to encourage banks to lend out all of their funds during the COVID-19 pandemic.
Before that announcement, banks with more than $1.216 billion in net transaction accounts had to hold 10% of deposits in reserve. They could hold them either in their banks' vaults or at the local Federal Reserve bank.
A bank lends any deposits above its reserves. These loans then get deposited in other banks. They only keep 10% in reserve, lending the rest. That's how $1 trillion in Fed credit can become $10 trillion in economic growth.
Adding credit to banks' reserves increases the money supply. Expansion of the money supply allows interest rates to fall.
Other Ways QE Stimulates the Economy
Quantitative easing stimulates the economy in three other ways.
QE Keeps Bond Yields Low
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, QE 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.
QE Attracts Foreign Investment and Increases Exports
Increasing the money supply also keeps the value of the country's currency low. This makes the country's stocks more attractive to foreign investors. It also makes exports less expensive.
QE Could Lead to Inflation
The only downside is that QE increases the Fed's holdings of Treasurys and other securities. For example, before the 2008 financial crisis, the Fed's balance sheet held less than $1 trillion. By July 2014, that number had increased to almost $4.5 trillion.
The more dollars the Fed creates, the less valuable existing dollars are. Over time, this lowers the value of all dollars, which then buys less. The result is inflation.
But inflation doesn't occur until the economy is thriving. Once that happens, the assets on the Fed's books increase as well. The Fed would have no problem selling them. Selling assets would reduce the money supply and cool off any inflation.
The most recent use of QE was in response to the COVID-19 pandemic. On March 15, 2020, the Federal Reserve announced it would purchase $500 billion in U.S. Treasurys. It would also buy $200 billion in mortgage-backed securities over the next several months.
On March 23, 2020, the FOMC expanded QE purchases to an unlimited amount. By May 18, its balance sheet had grown to $7 trillion. Fed Chair Jerome Powell said he was not concerned about the increase to the Fed's balance sheet. Inflation is not an issue and the Fed is able to hold onto any assets until they mature.
QE in Other Countries
Japan was the first country 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 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 ended the program.
QE in the United States
In 2008, the Fed launched four rounds of QE to fight the financial crisis. They lasted from December 2008 to October 2014.
The Fed resorted to QE because its other expansionary monetary policy tools had reached their limits. The fed funds rate and the discount rate were zero. The Fed even began paying interest to banks for their reserve requirements. As a result, quantitative easing became the central bank's primary tool to stop the crisis.
QE added almost $4 trillion to the money supply and the Fed's balance sheet. Until 2020, it was the largest expansion from any economic stimulus program in history. The Fed’s balance sheet doubled from less than $1 trillion in November 2008 to $4.4 trillion in October 2014.
QE1: December 2008 - June 2010
At the Nov. 25, 2008, Federal Open Market Committee meeting, the Fed announced QE1. It would purchase $600 billion in bank debt, U.S. Treasury notes, and mortgage-backed securities from member banks.
The Fed wanted to take these subprime MBS off of banks' balance sheets. The Fed had no risk because Fannie Mae and Freddie Mac guaranteed the securities.
By Feb. 24, 2010, the Fed had bought $1.25 trillion in MBS. It also bought $700 billion of longer-term Treasurys, such as 10-year notes. By March 2020, the Fed owned $2.3 trillion in securities. It ended this phase of QE because the economy was growing again.
Some experts worried that the massive amount of toxic loans on its books might cripple the Fed like they did the banks.
The Fed has an unlimited ability to create cash to cover any toxic debt. It was able to sit on the debt until the housing market recovered. At that point, those "bad" loans became good. They had enough collateral to support them.
QE2: November 2010 - June 2011
On Nov. 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. That would maintain the Fed's holdings at the $2 trillion level.
Its goal was to keep interest rates low to make housing more affordable. It also wanted to make Treasurys unattractive to force investors back into mortgages.
Some investors were afraid QE would create hyperinflation. Some started buying Treasury Inflation Protected Securities. Others started buying gold, a standard hedge against inflation. This sent gold prices soaring to a record high of $1,917.90 an ounce by August 2011.
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 of $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 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 considered QE4 to be 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.
The End of QE 2008-2014
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 7%.
- Gross domestic product growth was between 2% and 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.
On Oct. 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 would begin reducing its QE holdings. It would allow $6 billion worth of Treasurys to mature each month without replacing them. Each following month it would allow another $6 billion to mature until it had retired $30 billion a month. The Fed would follow a similar process with its holdings of mortgage-backed securities. It would retire an additional $4 billion a month until it reached 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. That's why QE1 was a success. It lowered interest rates almost a full percentage point. Rates fell from 6.33% in November 2011 to 5.23% in March 2010 for a 30-year fixed interest mortgage.
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 six largest banks in the U.S. hold more than $10 trillion in 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.
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