Quantitative Easing

Summary

Quantitative Easing refers to a process whereby the national banks increase the monetary supply by purchasing government bonds and other assets through money it creates out of nothing. This process can be broken down into the three following steps:

  1. The national bank declares an extremely low rate of interest, for example 0.5%.
  2. The national bank credits its own bank account with money created from 'thin air' through lending interests.
  3. The newly created money is then used for buying government bonds from financial firms such as banks, insurance companies and pension funds.

In March of 2009, the Federal Reserve announced that it would be initiating a program to purchase $300 Billion Treasury securities before September of 2009. In August, the Federal Reserve stated that it would be reducing the pace of investments to extend the program until in the end of October.

On November 3, 2009 the Federal Reserve began a second round of purchasing an additional $600 billion in long term Treasury securities. The New York Federal Reserve announced that it would also be reinvesting $250-$300 Billion in funds received from payments on principal from mortgage backed securities. This brings the total amount of QE2 to $850-$900 Billion, which was to be spent by the end of the second quarter of 2011.

(Much of the text below was taken from the Business Insider source)

 

What is Quantitative Easing

The term quantitative easing (QE) describes a form of monetary policy used by central banks 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.

A central bank does this by first crediting its own account with money it has created ex nihilo ("out of nothing"). 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. Due to rules that require banks to only possess a fraction of the money they lend out, each dollar given to the banks by the Treasury Department represents only a fraction of the money injected into the economy. The increase in the money supply thus stimulates the economy. Risks include the policy being more effective than intended, spurring hyperinflation, or the risk of not being effective enough, if banks opt simply to pocket the additional cash in order to increase their capital reserves in a climate of increasing defaults in their present loan portfolio.

"Quantitative" refers to the fact that a specific quantity of money is being created; "easing" refers to reducing the pressure on banks. However, another explanation is that the name comes from the Japanese-language expression for "stimulatory monetary policy", which uses the term "easing". Quantitative easing is sometimes colloquially described as "printing money" although in reality the money is simply created by electronically adding a number to an account. 

 

Concept

Ordinarily, the central bank uses its control of interest rates, or sometimes reserve requirements, to indirectly influence the supply of money. In some situations, such as very low inflation or deflation, setting a low interest rate is not enough to maintain an adequate money supply, and so quantitative easing is employed to further boost the amount of money in the financial system. This is often considered a "last resort" to increase the money supply. The first step is for the bank to create more money ex nihilo ("out of nothing") by crediting its own account. It can then use these funds to buy investments like government bonds from financial firms such as banks, insurance companies and pension funds, in a process known as "monetising the debt".

For example, in introducing its QE programme, the Bank of England bought gilts from financial institutions, along with a smaller amount of high-quality debt issued by private companies. The banks, insurance companies and pension funds can then use the money they have received for lending or even buying back more bonds from the bank. The central bank can also lend the new money to private banks or buy assets from banks in exchange for currency. These have the effect of depressing interest yields on government bonds and similar investments, making it cheaper for business to raise capital. Another positive side effect of this is that investors will swap to other investments, such as shares, boosting the price of these and increasing wealth in the economy. QE can also help in reducing interbank overnight interest rates, and thereby encourage banks to loan money to higher interest-paying bodies.

More specifically, in terms of the lending undertaken by commercial banks, they use a practice called fractional-reserve banking whereby they abide by a reserve requirement, which regulates them to keep a percentage of deposits in "reserve", which can only be used to settle transactions between them and the central bank. The remainder, called "excess reserves", can (but does not have to be) be used as a basis for lending. When, under QE, a central bank buys from an institution, the institution's bank account is credited directly and their bank gains reserves. The increase in deposits from the quantitative easing process causes an excess in reserves and private banks can then, if they wish, create even more new money out of "thin air" by increasing debt (lending) through a process known as deposit multiplication and thus increase the country's money supply. The reserve requirement limits the amount of new money. For example a 10% reserve requirement means that for every $10,000 created by quantitative easing the total new money created is potentially $100,000. The US Federal Reserve's now out-of-print booklet Modern Money Mechanics explains the process.

A state must be in control of its own currency and monetary policy if it is to be able to unilaterally employ quantitative easing. Countries in the eurozone (for example) cannot unilaterally use this policy tool, but must rely on the European Central Bank to implement it. There may also be other policy considerations. For example, under Article 123 of the Treaty on the Functioning of the European Union and later Maastricht Treaty, EU member states are not allowed to finance their public deficits (debts) by simply printing the money required to fill the hole, as happened in Weimar Germany and more recently in Zimbabwe. Banks using QE, such as the Bank of England, have argued that they are increasing the supply of money not to fund government debt but to prevent deflation, and will choose the financial products they buy accordingly, for example, by buying government bonds not straight from the government, but in secondary markets.

 

Quantitative Easing 1

On March 19, 2009 the Board of Governors of the Federal Reserve System announced that it would be purchasing $300 billion in long-term Treasury securities over the following six months. That same day, the Federal Reserve Bank of New York issued a press statement noting the purchases and indicating that those purchases would be made in the 2-10 year bond markets.

Release Date: March 18, 2009

For immediate release

Information received since the Federal Open Market Committee met in January indicates that the economy continues to contract. Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending. Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment. U.S. exports have slumped as a number of major trading partners have also fallen into recession. Although the near-term economic outlook is weak, the Committee anticipates that policy actions to stabilize financial markets and institutions, together with fiscal and monetary stimulus, will contribute to a gradual resumption of sustainable economic growth.

In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months. The Federal Reserve has launched the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses and anticipates that the range of eligible collateral for this facility is likely to be expanded to include other financial assets. The Committee will continue to carefully monitor the size and composition of the Federal Reserve's balance sheet in light of evolving financial and economic developments.

 

Statement Regarding Purchases of Treasury Securities

March 18, 2009

The Federal Open Market Committee (FOMC) has announced that the Open Market Trading Desk (the Desk) will begin a Treasury purchase program of up to $300 billion to help improve conditions in private credit markets. The Desk will concentrate purchases in the 2- to 10-year sector of the nominal Treasury curve, although purchases will occur across the nominal Treasury and TIPS yield curves. Consistent with prior outright Treasury purchases, these purchases will be conducted with the Federal Reserve’s primary dealers through a series of competitive auctions via the Desk’s FedTrade system. On average, the Desk will purchase Treasury securities two to three times per week. Further details will be provided early next week after consultation with the primary dealers and other market participants. The Desk plans to hold the first purchase operation late next week.

 

Changes to Quantitative Easing 1

On August 12, 2009 the New York Federal Reserve and the Governors of the Federal Reserve System issued press statements noting that it would slow the pace of purchasing the Treasury Securities. Originally, the Federal Reserve anticipated spending the money over a six month period from March to September. This statement noted that the pace would be altered in August to slow the spending so that it would be strung out to the end of October.

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. As previously announced, to provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt by the end of the year. In addition, the Federal Reserve is in the process of buying $300 billion of Treasury securities. To promote a smooth transition in markets as these purchases of Treasury securities are completed, the Committee has decided to gradually slow the pace of these transactions and anticipates that the full amount will be purchased by the end of October. The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. The Federal Reserve is monitoring the size and composition of its balance sheet and will make adjustments to its credit and liquidity programs as warranted.

 

Second Round of Quantitative Easing

On November 3, 2010 the New York Federal Reserve and the Governors of the Federal Reserve System both announced that a second round of purchases was to be made by the Treasury Department. The second round was dubbed as "QE2" by the media. The statement indicated that the Treasury Department would be purchasing $600 billion of longer-term Treasury securities by the end of the second quarter of 2011 at a pace of about $75 billion per month.

Release Date: November 3, 2010

For immediate release

Information received since the Federal Open Market Committee met in September confirms that the pace of recovery in output and employment continues to be slow. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls. Housing starts continue to be depressed. Longer-term inflation expectations have remained stable, but measures of underlying inflation have trended lower in recent quarters.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Currently, the unemployment rate is elevated, and measures of underlying inflation are somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate. Although the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, progress toward its objectives has been disappointingly slow.

To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.

The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate.

 

Statement Regarding Purchases of Treasury Securities

November 3, 2010

On November 3, 2010, the Federal Open Market Committee (FOMC) decided to expand the Federal Reserve’s holdings of securities in the System Open Market Account (SOMA) to promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate. In particular, the FOMC directed the Open Market Trading Desk (the Desk) at the Federal Reserve Bank of New York to purchase an additional $600 billion of longer-term Treasury securities by the end of the second quarter of 2011.

The FOMC also directed the Desk to continue to reinvest principal payments from agency debt and agency mortgage-backed securities into longer-term Treasury securities. Based on current estimates, the Desk expects to reinvest $250 billion to $300 billion over the same period, though the realized amount of reinvestment will depend on the evolution of actual principal payments.

Taken together, the Desk anticipates conducting $850 billion to $900 billion of purchases of longer-term Treasury securities through the end of the second quarter. This would result in an average purchase pace of roughly $110 billion per month, representing about $75 billion per month associated with additional purchases and roughly $35 billion per month associated with reinvestment purchases.

The Desk plans to distribute these purchases across the following eight maturity sectors based on the approximate weights below:

Nominal Coupon Securities by Maturity Range*

*The on-the-run 7-year note will be considered part of the 5½- to 7-year sector, and the on-the-run 10-year note will be considered part of the 7- to 10-year sector.

**TIPS weights are based on unadjusted par amounts.
Under this distribution, the Desk anticipates that the assets purchased will have an average duration of between 5 and 6 years. The distribution of purchases could change if market conditions warrant, but such changes would be designed to not significantly alter the average duration of the assets purchased.

To provide operational flexibility and to ensure that it is able to purchase the most attractive securities on a relative-value basis, the Desk is temporarily relaxing the 35 percent per-issue limit on SOMA holdings under which it has been operating. However, SOMA holdings of an individual security will be allowed to rise above the 35 percent threshold only in modest increments.

Purchases associated with balance sheet expansion and those associated with principal reinvestments will be consolidated into one set of operations to be announced under the current monthly cycle. On or around the eighth business day of each month, the Desk will publish a tentative schedule of purchase operations expected to take place through the middle of the following month, as well as the anticipated total amount of purchases to be conducted over that period. The schedule will include a list of operation dates, settlement dates, security types to be purchased (nominal coupons or TIPS), the maturity date range of eligible issues, and an expected range for the size of each operation.

The Desk expects to conduct the November 4 and November 8 purchase operations that were announced on October 13, and it plans to publish its first consolidated monthly schedule on November 10 at 2:00 p.m.

Purchases will be conducted with the Federal Reserve’s primary dealers through a series of competitive auctions operated through the Desk’s FedTrade system. Consistent with current practices, the results of each operation will be published on the Federal Reserve Bank of New York’s website shortly after each purchase operation has concluded. In order to ensure the transparency of our purchase operations, the Desk will also begin to publish information on the prices paid in individual operations at the end of each monthly calendar period, coinciding with the release of the next period’s schedule.

[1] Website: New York Federal Treasury Article: Statement Regarding Purchases of Treasury Securities Author: New York Federal Treasury Accessed on: 04/27/2011

[2] Website: Federal Reserve Bank of New York Article: Statement Regarding Purchases of Treasury Securities Author: Federal Reserve Bank of New York Accessed on: 04/27/2011

[3] Website: Federal Reserve Bank of New York Article: Statement Regarding Purchases of Treasury Securities Author: Federal Reserve Bank of New York Accessed on: 04/27/2011

[4] Website: Board of Governors of the Federal Reserve System Article: Press Release - Nov 3, 2010 Author: Board of Governors of the Federal Reserve System Accessed on: 04/27/2011

[5] Website: Board of Governors of the Federal Reserve System Article: Press Release - March 18, 2009 Author: Board of Governors of the Federal Reserve System Accessed on: 04/27/2011

[6] Website: Business Insider Article: What Is Quantitative Easing? Author: NA Accessed on: 04/27/2011

[7] Website: Board of Governors of the Federal Reserve System Article: Press Statement - August 12, 2009 Author: Board of Governors of the Federal Reserve System Accessed on: 04/27/2011

[8] Website: Wisdom of Rich Dad Article: Understanding Quantitative Easing (QE) Author: NA Accessed on: 04/27/2011