Quantitative easing is pretty much creating money to spend it. Nice eh?
So what is this whole thing we hear about Quantitative Easing? Ben Bernanke (the Federal Reserve Chairman) recently announced that the central bank is going to launch a “new and improved” form of quantitative easing until the labor market has rebounded. What does this mean? Until the economy turns around, the Federal Reserve will pump in money through the purchasing of long-term financial assets (such as mortgages). That is basically what Quantitative Easing is, use new money to buy assets, therefore flooding money into the economy with the hopes that banks will lend.
Now why are we talking about Quantitative Easing?
Well, unfortunately the powers that be have decided (probably rightfully) that we are in need of additional monetary expansion, that is we need to increase our money supply, in order to help the economy get back on the right track. I say unfortunately because Quantitative Easing is a last resort often for economies that have no other tools at their disposal.
Traditionally the central bank buys short-term bonds to lower bond interest rates, lowers the reserve requirement for banks, and pays less to banks storing money to incentivize increased loaning. The problem we have now is that our interest rates are close to zero, and we have exhausted these traditional means, especially if we ever want to be able to use them again.
Quantitative Easing is the answer we have been forced to take, since short-term interest rates are close to zero, the Fed can only lower long-term interest rates by buying bonds with longer maturity dates. The effort again is to encourage banks to lend.
What is this about QE3?
Well, we have tried Quantitative easing to combat our current economic crisis, twice in fact previously. In 2009-2010 the Federal Reserve announced it was injecting 1.7 trillion dollars into the monetary system by a little heard of method, known as Quantitative Easing. This was soon followed by an additional $600 package known as QE2.
So is QE3 just the third round of this bond buying? Not really.
The prior QE rounds had set dollar amounts that were injected quarterly, with an end to the purchase cycle. What Bernanke has recently announced is a continuous cycle of asset purchases, at the tune of $40 billion a month indefinitely. Well, at least until the markets stabilize and show positive signs of strong growth.
The problem we may have with “QE4-ever” has a lot to do with the downside risks to Quantitative Easing. As you already know, money is shoved into the system and banks are supposed to lend.
But do banks really lend? Well, that is debatable – but in theory, they should.
The real problem we need to be concerned with is inflation. Lately we have been hovering around 1.5-2.5% inflation, but this rate hasn’t been so stable. These rates are right around our target inflation rate. With additional Quantitative Easing, the Fed has to be very aware of the inflation rates and where they are heading, because flooding additional cash into a warming economy can be dangerous. Inflation rates of 3-5% are not horrible, and we could probably manage, but only if we are also growing. If we start climbing up above 5% and cannot bring along growth with that, we enter stagnation and we really don’t want to be there.
So the Fed has a lot on their plate moving along with these Quantitative Easing measures, and QE4-ever (QE3) is a dangerous, but perhaps necessary path to sustained recovery.
Has QE worked? If so, why QE3
I won’t get too much into this, partially because it would take forever, but also because the evidence is largely inconclusive (some say yes, some say no). But according the the International Monetary Fund (IMF), Quantitative Easing reduced the systemic risks during the financial collapse, helped turn the economy to modest growth, and increased investor confidence.
I hope you guys all learned something here, if you have questions, comments or feedback please let it be known!