Bernan[QE] – Understanding Quantitative Easing

BY: RAHUL ROKKAM, CONTRIBUTOR

You might have heard about quantitative easing (QE), but do you understand how it actually works? In fact, rarely anyone did before the 2008 financial crisis, when the Federal Reserve started the move to lower interest rates. The intention was to encourage the flow of credit and subsequently spur investment to kickstart the economy. In turn, investment would supposedly facilitate increased spending throughout the national economy, leading to inflation.

Why did the Fed attempt to create inflation—isn’t it a bad thing? Actually, it’s their job. One of the main roles of the Fed to keep inflation under control, somewhere between 1% and 3%, as good monetary policy both keeps inflation at low rates but prevents any deflation. Too much inflation induces hoarding—individuals try to keep as many commodities to themselves as possible to mitigate increased prices. It also decreases savings because when money is worth less, there is a reduced incentive to hold it since it loses value. Furthermore, purchasing power decreases since the dollar is worth less compared to other world currencies. That means overseas vacations get a lot more expensive.

On the other hand, deflation poses a far greater risk. A lower valued dollar leads to dropping prices, resulting in lower revenue and profits for firms. Consumers are next to be affected: stagnant wages, decreased turnover (which means less hiring), and layoffs become ubiquitous. But what clearly poses deflation as the greater risk between the two is when people realize prices are falling because goods and services every consecutive day they wait—it’s like a never-ending sale. So back to the interest rate crisis. How did the Feds, lead by chairman Ben Bernanke, attempt to stimulate a stagnant economy already at a 0% interest rate? They used an unconventional, controversial, and risky strategy—quantitative easing (QE).

So what is QE?

QE is a process in which a central bank buys significant amounts of assets, usually securities, from commercial banks and other intermediaries of financial markets. In turn, this raises the prices of the purchased assets as a result of increased demand. This lowers their yield while simultaneously increasing the supply of money in the economy. But let’s go through QE in a step-by-step process.

First, the central bank will “create” money with a click of a button, as opposed to printing it. This money that had not existed previously is used by the central bank to buy “toxic” securities from banks. For example, the central bank will buy tens of billions of dollars worth of CDOs (collateralized debt obligations), CLOs (collateralized loan obligations), bad bank loans, and other mortgage-backed securities. This ultimately increases the quantity of bank reserves in the economy, hence the name quantitative easing. How does this encourage banks to lend more? With the increased amount and less risky assets they now possess, stock values increase and interest rates decrease. This creates an incentive for them to loan to individuals and firms, as opposed to buying treasuries (remember, when the central bank buys billions of dollars of treasuries, the yield goes down). The central bank aims to reduce the incentive to buy treasuries and instead force lenders to look for options in the investment market.

Did Bernan[QE] work?

The first round of quantitative easing out of three, called “QE1,” started in November 2008 a few months after the  Lehman Brothers imploded. It lasted for 17 months, with the Fed buying around $100 billion in assets per month. From the beginning to the end of that 17 month period, the value of two critical commodities, gas and gold, had increased in value by 50%. At face value, this signaled success for QE1—but this controversy wasn’t without critics. Andrew Huszar, the leader of the QE program itself from 2009 to 2010, didn’t hold back in retrospect: “Despite the Fed’s rhetoric, my program wasn’t helping to make credit any more accessible for the average American. The banks were only issuing fewer and fewer loans. More insidiously, whatever credit they were extending wasn’t getting much cheaper. QE may have been driving down the wholesale cost for banks to make loans, but Wall Street was pocketing most of the extra cash.”

He points out that the largest intervention in central bank history pumped over $4 trillion in new money and bought assets into the economy, but only increased GDP by .25%, or $40 billion at the time. Furthermore, why have the US stock markets been rising after QE ended? It would be logical that if that QE ended and no new dollars were injected in the economy, the opposite result would occur. But let’s look at the big picture in early 2016: The US is achieving a solid 2.39% growth rate (GDP), a strong dollar in comparison to the currencies of emerging markets, especially the ruble, as well as consistent new job creation. This is even more impressive in comparison to the global economic situation—oil prices are at historic lows, emerging markets are enveloped in growing debt and contractions of growth, and stock markets are taking massive hits. China’s explosive growth is slowing down, Japan just enacted a negative interest rate, and Iran will soon flood the already supply surplus hit oil market with hundreds of thousands of barrels of oil per month. Does that mean QE is working? We aren’t sure yet. The Federal Reserve still retains trillions of dollars worth of securities that it must sell, through a process called “tapering.” Given past precedents, just the warning of such a measure has seen to roil global markets; $4 trillion worth of these assets might devastate the entire economic system largely based on US bonds and treasuries.

Will we see a shift from majority reliance on the dollar to other currencies with potential, such as the Chinese Yuan? Please leave your thoughts in the comments and Rahul will get back to you.

 

 

 

  • Nandagopal Polamada

    Excellent article Rahul. Liked the manner in which you have described this vast and complex subject in few lines. Shows that you have well researched and also analysed QE. My personal view being that other currencies with potential must emerge and Chinese Yuan seems a strong contender. However, in near future USD stands tall.