- Tools for Investors
- Stock News
- Investing Ideas
- Econ & Policy
- Personal Finance
Since late 2010, the Federal Reserve has undertaken a monetary policy strategy known as quantitative easing or QE2. Exactly what is this oddly-named initiative? How does it differ from the Fed’s normal monetary policy? Is it likely to succeed in getting the sluggish US economy back on track?
What is quantitative easing?
Quantitative easing (QE) means large-scale purchases of securities by the Federal Reserve in an attempt to stimulate the economy. To carrying it out, the Fed buys government securities from private dealers and pays for them by transferring funds to the dealers’ bank accounts. When the payment is completed, both the total deposits and the total reserves of the banking system increase. If the process works as intended, the banks put the new reserves to work by increasing their lending to businesses and consumers. The whole process increases the quantity of money in circulation and stimulates the economy.
How does QE differ from standard monetary policy?
Quantitative easing is an extension of the Fed’s normal open market operations, which also involve the purchase of government securities from private dealers. However, QE differs from normal open market operations in three important ways:
1. The scale of QE is much larger. Normal open market operations are used to make week-to-week adjustments to bank reserves of a few tens or hundreds of millions of dollars. The QE program that began in November 2010, when carried to completion by mid-2011, will total $800 billion.
2. The aim of ordinary open market operations is to nudge short-term interest rates up or down by a fraction of a percent. The interest rate the Fed watches most closely is the federal funds rate, which is the price banks charge when they make overnight loans to one another. The Fed is said to ease monetary policy when it nudges the federal funds rate lower or to tighten it when it nudges the rate higher. In contrast, quantitative easing is brought into play only when short-term interest rates have been pushed so close to zero that they can go no lower. When that happens, the Fed can no longer ease policy by adjusting the price of reserves, so it turns its focus to adjusting the quantity of reserves. That is where the name “quantitative easing” comes from.
3. Ordinary open market operations are conducted either by making outright purchases and sales of short-term Treasury bills, or by conducting repurchase agreements, which have an even shorter term. In contrast, QE involves the purchase of longer-term securities with maturities of several years. Because long-term interest rates are normally higher than short-term rates, it is thought that QE can push long-term rates lower even when short-term rates have fallen as low as they can go. To the extent that business investment and consumer purchases of housing and durable goods depend on long-term interest rates, QE can stimulate demand and speed economic recovery.
Why is the Fed’s current program called QE2?
The program that was announced in November 2010 was not the first time the Fed had used quantitative easing. As the global financial crisis deepened in the second half of 2008, the Fed used conventional tools to ease monetary policy and to decrease the federal funds rate. By year’s end, the fed funds rate had reached a range of 0 to .25 percent, as low as it could go. At that time the Fed began buying longer-term debt, including mortgage-backed securities issued by Fannie Mae and Freddie Mac, as well as additional Treasury securities. That first round of quantitative easing leveled off in mid-2009 after well over a trillion dollars of purchases.
By 2010, it was clear that the recovery was not progressing as fast as had been hoped. When the Fed began discussing a second round of quantitative easing in mid-2010, the financial press started calling it “QE2.” The term caught on because it distinguished the new program from the early one (which now became known as QE1), and also because the huge scale of the program reminded people of the giant ocean liner Queen Elizabeth II.
Will it Work?
QE2 is highly controversial. It has majority, but not unanimous, support on the Federal Open Market Committee, the Federal Reserve unit that makes such monetary policy decisions. Outside the Fed, some observers are convinced QE2 is the last, best hope to reboot a stalled economic recovery, some think it will have disastrous unintended consequences, and some think it will fail to do much of anything one way or the other. Here are a few of the principal points of controversy:
The bottom line
The bottom line is that QE2 has few precedents and uncertain results. It was undertaken only because conventional monetary and fiscal policy had failed to restore growth and reduce unemployment. There is solid ground to hope that it should work, but no guarantee that it will. QE2 is not entirely without risks, but policy makers at the Fed argue vigorously that they are aware of its pitfalls and are ready to implement a quick exit strategy if things take a turn for the worst.
Don't miss one of the biggest bull markets in history! Covers Gold, Silver, Gold & Silver stocks, and miners.
There's always a bull market in some sector! Find the best opportunities in commodities.