What is Quantitative Easing ?

Quantitative easing is an alternative way that modern central banks have invented to prop up the economy in a short period of time after a crisis. This technique was extensively used by the Federal Reserve i.e. the central bank of the United States to prop up the economy after the slump of 2008. The Fed had conducted 3 major rounds of quantitative easing and has been using the technique ever since on a regular basis. There is widespread debate on the uses and possible dangers of this technique. On one side, some people refer to this as a wonderful tool in the kit of a central bank whereas on the other hand, others simply refer to this as counterfeiting money.

The Significance

As the above definition states, quantitative easing is simply the addition of additional money supply into the system. This is significant because it is only in the recent years that all the prosperous central bankers across the world have started doing this. Banks like Federal Reserve, European Central Bank and the Bank of Japan all used interest rates to regulate the economy. For instance, in case credit was tight and banks were not lending enough, these central banks would simply cut the rates to boost lending. They would do the exact opposite and raise rates when there was excess lending going on and there was danger of inflation.

However, in the crisis of 2008, these measures did not seem to be working. All the aforementioned Central Banks had almost slashed their interest rates to zero! Yet they were not able to spur lending. It is then that the banks turned to quantitative easing.

The Methodology

When central banks use quantitative easing, they inject money into and remove money from the economy as required. For instance, they can have a target amount of lending that needs to be done and a target inflation rate that needs to be met. In case, the inflation is too low but so is the lending, the central banks can create new money using quantitative easing and then buy new assets. The basic premise is that the Fed does not buy bonds from already existing money rather the Fed creates new money when it makes these purchases. The new money supply drops the lending rate of the existing money and is theoretically supposed to boost the lending in the economy and therefore cause an increase in the economic activity.

Asset Purchase Program

Quantitative easing involves central banks buying large quantities of assets from the market. The central bank buys these assets with money that it creates. Therefore the amount of assets that the Fed buys is the amount of money that has been pumped into the system.

For instance, consider the case of the massive bailout of 2008. Prior to 2008, the Feds balance sheet stood at $880 billion. This meant that the amount of money that Fed pumped into the system for all these years stood at $880 billion. Then, it started quantitative easing and by the year 2015, the Feds balance sheet stood at over $4 trillion. The Fed had almost raised the money supply by five times in that very short time frame.

Fractional Reserve Banking

All the money that is created by the Fed for these asset purchases is high powered money. This means that this money is used as reserves by the banks based on which they can expand the money supply even more. Thus, for every dollar that is issued by the Federal Reserve to buy bonds in the name of quantitative easing, several more dollars end up in circulation in the market through the use of fractional reserve banking. Hence, the Federal Reserve is capable of causing severe inflation through its asset purchase program. In fact, there is a prevailing viewpoint amongst critics that the Fed has used these expansionary policies to artificially prop up all the asset markets and hide its failure from the subprime mortgage crisis.

Quantum of the Issue

The sheer scale of quantitative easing makes it a mind boggling affair. Now, we already know that the Federal Reserve’s balance sheet has grown by a factor of 5 in the 7 years post the subprime crisis! This is because the Fed is pumping $85 billion dollars into the market each month through asset purchases. The Fed basically buys US treasury bonds from whichever bank can offer it to them at the lowest rate.

The problem is that now the US government, the Treasury and the Federal Reserve want to put an end to quantitative easing. However, the market has literally grown dependant on the liquidity shots that are provided by the quantitative easing. Hence, if the Fed were to stop buying bonds now, it would end up creating a severe demand shortage in the markets since its $85 billion per month purchases create significant demand in the market.

Therefore, the issue of quantitative easing is today at the heart of international financial matters and is highly discussed by global bodies such as World Bank and IMF! Markets all across the world are connected to the United States. Hence any policy change in the US pertaining to this policy of quantitative easing is likely to have global ramifications. Therefore, the world has its eyes set on how this policy is finally going to play out!