Imagine a world where the interest rate is practically zero. People don’t make a profit in saving their money and borrowing money from banks takes less risks than ever before. And yet, firms and entrepreneurs are still disinclined to make investments because people are not willing to consume. Production is decreasing. Unemployment is increasing.
Ok, kind of obvious that this is the US several years ago. (Lots of other countries too, but in the finance course I’m taking, we only talk about the US.) The Federal Reserve has adjusted the Federal Funds rate to as low as it can be, but still couldn’t help the economy in stagnancy. You were elected the president of the federal reserve and on the first day as the chair, everyone in the office is staring at you and asking you with their innocent eyes:
Watcha gonna do?
You rub your hand against each other for way too long, looking like a big mosquito in front of everyone. You stare at one single thread of knit on the carpet, and finally you lift up your head and said:
“Let’s go with QE.”
People sigh and all go back to work.
So what is QE? QE stands for Quantitative easing.
Basically it is saying that quantitative easing is a method used to boost the economy after the traditional methods such as adjusting Federal Funds rate and buying bonds have failed. It targets at longer-term financial assets such as long term T-bonds, mortgage, and real estate. (Of course not real estate this time, because the whole crisis was originated in the real estate market.) The Fed (short for Federal Reserve from then on) would buy these financial assets, thereby injecting money to the banks, increasing their reserves. With more reserves, banks are more willing to lend out money which encourages firms and entrepreneurs to make investments.
However, as my professor mentioned, the banks have to be willing to lend out their excess reserves to let quantitative easing affect the economy. Why would the banks not want to lend out their reserves? Because in the banks’ loans, there are many are going bad and the banks don’t expect those returns. Since the firms behind those bad loans could announce bankruptcy any minute, there is a chance for banks to be in debt any minute. Therefore, banks want to hold onto safe money for as long as possible.
To tackle this dilemma (in the context of 2008 financial crisis), quantitative easing is divided into several stages.
The Fed bought MBS (Mortgage Backed Securities), a mortgage associated with the real estate market that are going bad, from the bank to reduce the risk on banks shoulders. (T stands for trillion, which is 1,000,000,000,000. Not a small number.) Banks with less bad mortgages are encouraged to lend out more money. Simultaneously, the Fed bought large amounts of bonds from bond dealers, injecting large amounts of money to the banks’ reserves. (Learn how bonds and the bond market work, click here and here.)
The Fed realized that stage 1 was no way close to securing the banks or boost people’s confidence in the economy. So it buys a even larger amount of long-term bonds, which is very unfavourable for the Fed, because the return won’t be seen before a long time. This is purchase serves the same purpose as stage 1 “easing” the banks’ “tension.”
The first two stages of easing showed some effects, so it transformed to a more gradual approach. The fed promises to buy a certain amount of MBS per month, so that the banks know that even though there are still many bad loans, their returns are promised by the Fed. (The Fed is always reliable and we will talk about why later.)
These are the three stages of quantitative easing, and technically we are still stage 3 even though the Fed has already lowered their monthly purchase of MBS to a significantly lower amount.
People have more confidence in the economy and the recession is fading away. You have saved the economy and completed your task, congratulations!
Maybe, at the back of your head, you are still wondering why the people sighed the day you announced quantitative easing.
The concern was that since the production of the nation was not increasing but decreasing, the injection of such a big amount of money may cause inflation. People are holding more money with less products and services to purchase. The dollar value will go down.
Why didn’t inflation occur this time? Because the economy was in deflation. Prices were going down, and dollar value was going up, because people are less inclined to spend their savings. This is a gradual process obvious enough that everyone sees it. Why would you spend a dollar today when you know that tomorrow the same dollar is worth more? The inflation and deflation cancelled out so the dollar value remained largely unchanged during the course of this quantitative easing. All is well.