What is it?
Quantitative easing has, been one of the controversial terms ever created. Quantitative easing means buying of assets by a nation’s central bank in order to inject money into the financial system. Usually, central banks try to raise the amount of lending and activity in the economy indirectly, by cutting interest rates. Lower interest rates encourage people to spend, not save. However, when interest rates can go no lower, a central bank’s only option is to pump money into the economy directly. That is quantitative easing (QE).
A central bank does this by first crediting its own account with money it has created out of nothing. It then purchases financial assets, including government bonds and corporate bonds, from banks and other financial institutions in a process known 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. 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. Expansionary monetary policy typically involves the central bank buying short-term government bonds in order to lower short-term market interest rates, however, when short-term interest rates are either at, or close to, zero, normal monetary policy can no longer lower interest rates. Quantitative easing may then be used by the monetary authorities to further stimulate the economy by purchasing assets of longer maturity than only short-term government bonds, and thereby lowering longer-term interest rates further.
It was tried first by a central bank in Japan to get it out of a period of deflation following its asset bubble collapse in the 1990s.
The global economy is flooded with successive waves of liquidity generated over the past few years by the most superior economies like US, UK and Japan.
Quantitative easing in the US:
For the preceding fifty years or so, the key device of monetary policy has been the Federal Funds rate. During the current crisis, however, the Federal Reserve unveiled a range of new policy measures never used before in its times past. What enforced its hand initially was the difficulty of credit markets in the wake of the decline of the subprime mortgage market, which began in August of 2007. By December of 2008, however, a subsequent factor came into play: The Funds rate effectively reached its zero lower bound, implying that, regardless of the severity of the recession, the unadventurous option of reducing the Funds rate was no longer accessible. The new exceptional measures afforded the Fed the only opportunity for stimulating the economy.
Because of their spectacular impact on the size of the Fed’s balance sheet, the most noticeable of the new policy measures have been large asset scale purchases (LSAPs), known more generally as quantitative easing (QE). Soon after the meltdown of the shadow banking system that followed the Lehman failure in September 2008, the Fed initiated what recognized as QE1: the purchase over time of a range of high-grade securities, including agency mortgage backed securities (AMBS), agency debt, and long-term government bonds. It also set up a commercial paper lending facility, which effectively involved the purchase of commercial paper since the Fed accepted these instruments as collateral for the loans made to the facility. In October 2010, the Fed announced a second wave of asset purchases (QE2), this time limited to long-term government bonds and smaller in scale than QE1. Finally, in September 2011, the Fed embarked on a variation of QE, known as Operation Twist. This action was fundamentally an uncontaminated acquisition of long-term government bonds financed by selling some of its short-term bonds. In compare to the first two rounds of QE, this round is open-ended – meaning that the Fed can keep pumping money into the system for an indefinite period. To being larger in scale, QE1 differed from the other LSAPs in several important respects. First, the asset purchases involved securities with at least some degree of private payoff risk, whereas QE2 and Operation Twist were restricted to the acquisition of government bonds. In addition, QE1 was undertaken at the pinnacle of the crisis when financial markets and institutions were under utmost pressure. By contrast, QE2 and Operation Twist were undertaken in periods of greater normalization of credit markets. Exactly which of these factors could account for differences in the impact of various LSAP programs has yet to be resolved. In its declaration, the Fed set forth the diagram that if the outlook for the labour market does not recover substantially; the committee will carry on its purchases of agency mortgage-backed securities, commence additional asset purchases, and employ its other policy tools as suitable until such improvement achieved in a framework of price stability.
A lengthy experiential literature has emerged attempting to identify the effects of the LSAP programs on market interest rates and economic activity. However, not without substantial controversy, a common theme of this research is that the LSAPs have without a doubt been effective in reducing various interest rates and interest rate spreads and, as a consequence, in stimulating economic activity. At the same time, given the vivid nature of much of this empirical work, the exact mechanism through which LSAPs may have affected the economy remains an open question.
What does it do?
Quantitative easing cuts borrowing rate. The idea is to discourage savings by individuals and businesses. The US economic growth is dependent on spending by individuals and businesses for consumption of goods and services. With interest rates staying at near zero percent, individuals and businesses are forced to invest in risky assets like stocks, bonds or debt instruments or commodities to earn a return on savings. This floods money into global investment institutions.
Why world bothers?
Federal Reserve Chairman Ben Bernanke hinted that the program of quantitative easing that has propped up the economy and the markets over the last three years could end before Christmas comes around. Overnight, the Japanese stock market dropped 7% in a single session. It was followed by sharp corrections in other markets around the word. No great surprises there. If it is QE that has been keeping the markets buoyant despite a global economy that is flat at best, then it made sense that withdrawing the sugar rush of printed money would send equities crashing. QE is certain to end sometime. No one quite knows when — even Bernanke himself probably has not made his mind up yet. However, when it does, the results will not be what everyone thinks they will be. In truth, quantitative easing is an experiment. No one had tried it until the Japanese experiment started a decade ago. In addition, certainly no one has ended it before. Therefore, we cannot have any real idea what precisely will happen.
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