The Corona virus pandemic has been an adverse shock to the economy. Employment and businesses have been hit hard. Thus, the Federal Reserve has adopted zero-rate lending for financial institutions. It has also launched a $700 billion Quantitative Easing program. The purpose of the program is to achieve an explicit macroeconomic objective; by sheltering the economy from the effects of the virus.
Quantitative Easing, a rather unconventional monetary policy, enables the central bank to purchase long-term securities; government bonds or other financial instruments. The central bank, after that, injects the money (liquidity) into the economy to maintain its economic activities. With this in mind, we’ll add perspective to this theory. Let’s practically delve into the U.S. experience with Quantitative Easing.
How Easing Works (U.S Experience with Q.E.)
You may be asking yourself, isn’t the U.S Federal Reserve (Fed) at the risk of ‘running out of ammunition?’ Well, Quantitative Easing is effective in improving macroeconomic conditions. Additionally, the supposed lower bound on the official interest rates is not a constraint of the effectiveness of the monetary policy. It has found widespread use across significant banks in the world. Some include; Federal Reserve, Banks of Japan, and the European Central Bank. We can back this claim with previous large scale asset purchases from 2009 to 2014 by the U.S Federal Reserve.
Global Economic Crisis, 2008
In the wake of the global economic crisis in 2008, the Federal Reserve applied several rounds of Q.E. to bring back the economy on its feet. The Fed started growing its balance sheet by buying government bonds and mortgage-backed securities. The first round of Q.E., later dubbed as QE1, had the Fed buy $100 billion of agency debt and $500 billion of mortgage-backed securities. In March 2009, the Fed extended with another $850 billion to mortgage securities and deficits. The Fed also siphoned another $300 billion in long term treasuries. The second round, QE2 was in November 2010, the Fed bought $600billion worth of long-term Treasuries by mid-2011.
In September 2011, the Fed started a new maturity program called Operation Twist. In this, the Fed would increase the average maturity of the bank’s treasury portfolio. Hence, it bought $400 billion worth of treasuries maturing between 72 and 360 months. It sold off a similar amount of treasuries with a maturity ranging between 3-36 months. The third Quantitative Easing round began in September 2012. The central banks spent almost $40 billion monthly in mortgage-backed securities. Together with Operation Twist, it was responsible for $85 worth of long term bonds purchases. In December 2013, the Fed indicated a taper. Following this, the $85 billion monthly spending would be reduced by $10 billion onward. The end of the QE3 program came in October 2014.
When is Quantitative Easing Used?
Quantitative Easing most applies when short-term nominal interest rates are almost zero. As such, they can’t be reduced any further to boost an economic function. In simple terms, the unconventional monetary policy applies where conventional monetary policy has failed. Using Q.E., the Fed purchases debts and mortgage-backed Securities from banks, in exchange to electronically create money. As a result, the number of assets purchased swells the Fed’s balance sheet.
When the Federal Reserve purchases financial instruments, it increases the money supply in the economy. However, this results in some sort of disequilibrium as individuals hold more cash than they need. They put the extra money on assets such as bonds, real estate, and stocks. Hence, the prices of these assets shoot, reducing the profits of these assets.
As the Fed buys these instruments, it automatically creates demand for them. In turn, the prices pull up, lowering their yield. Thus, the economy achieves a new but lower equilibrium. The lower interests boost borrowing, investing, and investing. It kick-starts economic growth.
How Quantitative Easing Affects You
When economic times are hard, people often worry about losing their jobs and how they’ll spend their money. In turn, businesses lose their customers. As discussed in this article, commercial banks use Quantitative Easing to encourage spending and investments. We’ll take you through the effects of Quantitative Easing.
- Increased prices of shares and property. It is due to changes in bank rates on deposits and pay on bank loans.
- The cost of providing pensions rises as the prices of government bonds go up. It is because the government bonds gives an estimate of how much it will cost to provide a pension. In turn, firms are under an obligation to make a more significant payment into their pension schemes.
While quantitative Easing can fuel the economy, it can dig a country into a deeper hole. It should be used long enough to promote viable and lasting improvement. However, a continuous Quantitative Easing program has serious consequences. It should be reserved in situations where a country feels it’s the final option.