What the heck is Quantitative Easing?

Doug Marshall, CCIM
Market Assessment

If you’ve listened to the news or read a newspaper in recent weeks there is a new buzz phrase being bandied about: Quantitative Easing. So what is it?

The term Quantitative Easing (QE) describes a form of monetary policy used by The Federal Reserve to increase the supply of money in an economy when the bank interest rate, discount rate and/or interbank interest rate are either at, or close to, zero.

The Federal Reserve does this by first crediting its own account with money it has created ex nihilo ("out of nothing") or some would say, by “printing money.” It then purchases financial assets, including government bonds and corporate bonds, from banks and other financial institutions in a process referred to as open market operations.

The purchases, by way of account deposits, give banks the excess reserves required for them to create new money by the process of deposit multiplication from increased lending in the fractional reserve banking system. The increase in the money supply thus stimulates the economy.

What is the purpose of Quantitative Easing?

The Federal Reserve has been given two mandates:

1. It is charged with ensuring full employment in the United States; and,

2. It is also charged with ensuring price stability. Inflation, in recent months, as measured by the CPI (Consumer Price Index), has declined to almost zero which is well below its target of two percent annually.

The Fed hopes that QE will stimulate the economy and thereby ease unemployment.

The Fed also hopes QE will bring the U.S. closer to its stated long-term inflation target.

The primary risk of QE is that it can spark inflation greater than desired or even hyperinflation. Or it could have no impact whatsoever.

Ben Bernanke, Chairman of the Federal Reserve, may be the “smartest guy in the room” but when he’s tweaking the largest economy in the world it is near impossible to really know what the impact The Fed policies will have on the economy.

What has been the impact of Quantitative Easing so far?

The first round of Quantitative Easing took place at the height of the financial crisis in late 2008 and early 2009. What impact did QE have on the economy and interest rates? Good question. I’m not sure anyone knows for sure.

Just recently the Federal Open Market Committee announced another round of Quantitative Easing called QE2. The Fed plans to purchase over $600 billion of long-dated Treasury securities over a period ending in June 2011.

Economists are debating what impact QE2 will have on interest rates. Ted Jones, PhD, Chief Economist for Stewart Title, says it has already significantly increased interest rates and uses the following table to support his position.

The table details the changes in constant-maturity Treasury rates since August 1, 2010. While rates are still comparably low, they have risen significantly in recent weeks.

As noted below in the table three-year Treasury yields are up 80 percent from the low just two weeks ago while two-year notes are up 60 percent. Even the 30-year Treasury yield has jumped 24+ percent since the end of August.

As convincing as this table is in supporting Dr. Jones’s opinion, I don’t think anyone can know for sure if the recent rise in interest rates can be directly attributed to the announced purchase of $600 billion of treasury securities over the next several months.

It seems to be too sharp of a rise in rates and it happened too quickly after The Fed announcement to be attributed to QE2.

But then again, who am I to disagree with such a distinguished and well qualified expert? We should know though in the next few months whether Dr. Jones is right or not. Let’s hope for all our sakes he’s not.

Sources:
Quantitative Easing by Wikipedia;
Does Quantitative Easing Work in Boosting the Real Ecomony? by Edward Harrison, November 4, 2010;
'Quantitative Easing': What Does It Really Mean for Investors?, Jeff Cox, CNBC.com, August 23, 2010;
Quantitative Easing Already Goosing Interest Rates, Ted Jones, Jones on Real Estate blog, November 14, 2010.