Abacus: Simplifying Quantitative Easing
Quantitative easing has become known as one of the most transcendent policies used by the United States during periods of economic downturn.
Often after it has been established that the country is in recession, with unemployment rising and growth diminishing, people reading newspapers and watching business channels on television may learn about various actions taken by the Federal Reserve, the nation’s central bank, to prevent further impairment to the economy.
One series of actions taken by the Fed during economic slumps makes up the seldom-used quantitative easing, known to many bankers simply as QE.
Despite any beliefs regarding the intricate nature of QE, one may find it very useful to understand how the economic strategy is implemented and the effects it can have on an economy. There are two primary tools used by the US during recessions: fiscal and monetary policy. Fiscal policy concerns the use of government spending and taxation, both of which are tools at the discretion of the President and Congress.
According to macroeconomic theory, the government should increase spending and lower taxes during times of economic contraction in order to revive consumer spending.
When the economy is doing well, the opposite actions (less spending and higher taxes) should be taken in order to assure that inflation, the rise in the price level, do not increase too high rates.
On the other hand, QE is a form of monetary policy, which the Fed is directly in charge of. In its simplest form, QE is the purchase of various long-term securities, namely bonds, that consequently increases the flow of money into the economy. The increase in the money supply has the indirect effect of lowering key interest rates, which incentivize individuals to finance large purchases, such as a college education, an automobile, or a house, and stimulates firms to fund their own investments.
Yet, there is far more that should be understood of QE as a whole. In particular, it is interesting to examine the exact process the Fed takes in conducting monetary policy.
With the goal of lowering interest rates to increase nation-wide demand from consumers and businesses alike, the Fed typically purchases many short-term Treasury bills. Such bonds usually offer a maturity, or length of time before the security expires, of one year or less, making it less risky to hold than bonds that have maturities of several years, all other factors considered.
When the Fed buys bonds, the inverse relationship between the yield on the bond and its price becomes evident.
There are a few factors that contribute to the negative relationship between a bond’s price and its interest rate. For example, consider a business that issues bonds to individuals so that it can raise money to finance its ventures.
One such bond that it could issue may be a 5-year bond that has a price of $1,000 and an annual yield of 5%. If someone wishes to purchase this bond, they would have to pay the firm $1,000 and, over the course of the next five years, they would receive 5% of that initial payment ($50) each year before receiving their full $1,000 at the end of the fifth year.
As a result of the transaction, the purchaser of the bond earns a profit, and the business gains must-needed funds.
(Source: Federal Reserve/ 2019) Jerome Powell, head of the Federal Reserve
On the other hand, if the demand for bonds were to increase across the nation, the price of that bond would likely rise. If the price were to increase, 5% of the new price would no longer be $50, but more. If the firm wishes to still only make yearly payments of $50 to the purchaser of their bond, they would have to lower the interest rate on the bond such that 5% of the new price is $50.
Hence, an inverse relationship exists between a bond’s price and its interest rate. As a consequence of the Fed purchasing many short-term securities during the housing crisis-originated recession of 2007-2009, the yields on various bonds fell sharply. For instance, the interest rate on a 3-month Treasury bill fell to as low as 0.03% in December 2008, just 22 months after the rate was more than 5%.
Despite such low rates, the economy remained in one of its worst conditions in modern history, with the national unemployment rate reaching 10% in October 2009 for the first time in 26 years.
In order to further increase the money supply, the Fed conducted unprecedented US monetary actions by buying securities with longer maturity dates. Specifically, Treasury bonds with long term lengths were a common purchase.
Bonds that have long maturity lengths are riskier assets to invest in than bonds with short maturity lengths, all other factors held equal because it is more probable that the entity issuing a long-term bond, such as the government or a corporation, is likely to default on its payments for the bond.
As a result of the increased risk, higher interest rates are typically offered on long-term bonds as a premium. So, when the Fed purchased these bonds with higher yields, the interest rates on the securities fell at a greater depth than the rates on the shorter-term assets.
Moreover, the Fed purchased mortgage-backed securities that many investment banks created during the housing boom of the early to mid-2000s. These types of securities are linked to a collection of mortgages. In normal times, even when a small number of homeowners defaulted on their loans, mortgage-backed securities helped provide income for those who invested in them.
However, as millions of people defaulted on their loans during the financial crisis, the value of these securities dramatically declined, with the banks who issued them facing the consequences in the forms of lost income and strict tightening to their lending capabilities.
The Fed bought many of these securities to relive banks, while the Troubled Asset Relief Program granted investment in financial firms that were most harmed by the crisis, with billions of dollars going towards improving credit environments, stabilizing banks, and enhancing stock value.
With QE again being used today in the aftermath of the shock to the US economy delivered by the COVID-19 pandemic, it is worth noting certain criticisms some pundits have had of the policy. One position of QE is that it can lead to high rates of inflation.
High inflation can lead to severe repercussions as it relates to a variety of aspects of an economy, one of which concerns the diminishing value of the money individuals hold in retirement and other investment and savings accounts. As a result, it is arguably wise to only institute QE during times of low inflation.
Throughout the periods when QE was primarily used to combat the last two recessions (starting in late 2008 and through 2020), the inflation rate in the US has been quite low, with it not surpassing 4% in either time frame and remaining at or near 2% for many years.
Despite the unparalleled purchases of securities, one possible reason why prices for consumer goods did not broadly increase was due to the severity of the recession and the slow and steady recovery of the economy through the 2010s, both of which limited aggregate demand.
An additional adverse effect of QE involves the lending practices of banks that benefit the most from the Fed’s actions. In particular, with an influx of new money and the relief of risky assets, such as the low-value mortgage-backed securities of the late 2000s, many banks are incentivized to create financial products that may be perilous but have high-profit potential.
This problem is especially serious considering many institutions know the government may bail them out if they become insolvent, given their importance to the country’s financial foundation and the broader economy.
QE has become one of the most noteworthy and controversial economic policies of the modern-day. Regardless of one’s distinct views on the topic, it can be healthy for any society to obtain a good knowledge of how its government reacts to crises that may occur naturally.
Understanding valid criticisms of any proposed action are significant in devising a policy that is effective and minimizes pernicious effects.
