Q is Quantitative Easing for Dummies

Q is Quantitative Easing for Dummies
Personal Finance from A to Z
Eileen St. Pierre, The Everyday Financial Planner

Since the financial crisis in 2007-2008, the Federal Reserve (FED) has been using a strategy called Quantitative Easing to try to get us out of this mess. There have been three rounds of it, known affectionately as QE1 (December 2008), QE2 (November 2010), and QE3 (September 2012). The FED has now started to cut back on this program, in a process known as tapering.

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Asking “What is Quantitative Easing?” is not a dumb question. To answer this question, you first need to understand why this approach was used in the first place.

 

 

Interest rates were cut to near zero.

In responding to the collapse of the housing market and the ensuing financial crisis, the FED had to act quickly. Normally, to stimulate the economy, the FED would buy short-term government securities from banks, increasing bank cash reserves, which would lead to lower interest rates. The hope would be that banks would then lend this money out to consumers and businesses, stimulating economic growth and helping the housing market recover. It did this until interest rates fell to close to zero. Once interest rates approach zero, this strategy is no longer effective. But the economy still needed help, so the FED had to resort to unconventional strategy.

That’s where Quantitative Easing comes in.

The FED now had to directly pump money into the economy – Quantitative Easing – because it could no longer do it indirectly through interest rates. The FED began buying longer-term government securities and mortgage-backed securities from banks and other financial institutions. This caused the prices of these securities to go way up in value. The hope was that investors would find these securities too expensive and put their money somewhere else, thus leading to economic growth.

  • This explains why we have seen such a run up in stock prices as investors search for higher yields.
  • However, demand for government securities did not fall as much as anticipated because the rest of world’s economies were worse off than ours. The U.S. government was still seen as a good investment compared to the rest of the world.
  • Economic growth has not picked up as much as anticipated. Many banks are still hesitant to lend money so they are holding on to this influx of cash in reserves. Businesses have not seen strong increases in demand, so they are holding off hiring and making capital investments.

What happens next?

The FED has started to slow its asset purchases, but the question that keeps being asked is when will the FED finish its tapering and start selling the huge amount of assets it has accumulated (now over $4 trillion).

  • There are concerns over how this selling will affect asset prices. Watch how the stock market reacts every time the FED meets.
  • With so much money injected into the economy, some are concerned that inflation may rise. Inflation has remained in check so far (despite what you might think every time you fill up your gas tank).

Whatever the FED does next, you can be assured that it will be measured. Expect baby steps, not giant leaps. FED Chair Janet Yellen is no dummy.