QUANTITATIVE EASING (QE)

Quantitative Easing (QE)

Quantitative Easing (QE)

Introduction

Quantitative easing (QE) is when the Fed buys various assets such as mortgages and Treasury bonds for the purpose of increasing the money supply, or in this case, to provide our fiscally challenged government and banks with money to help clean their books and keep them going for a while. The Fed buys these assets with money created "out of nothing".

This method is only used when the usual method of manipulating interest rates to control the money supply has failed. When the Fed lowers interest rates money is added to the system.

Conversely, when the Fed raises interest rates the money supply is contracted. But with the interbank interest rate currently at .25 percent (effectively zero), the Fed can't lower interest to increase the money supply. With that tool now rendered mute, quantitative easing is being called for.

Discussion

QUANTITATIVE easing (QE) is an ugly name for a simple idea. Central banks buy long-term government bonds with newly printed money. This raises the bonds' prices, lowers their yields and provides a helpful boost to growth when central banks' main tool, the short-term interest rate, is close to zero.

There are plenty of disputes over whether QE works, but not over who should be doing it: the central bank, obviously. America tried precisely that in 1961. To lower long-term rates the administration of John Kennedy persuaded the Federal Reserve to co-operate with the Treasury in selling (shorter-term) bills and using the proceeds to purchase (longer-term) bonds. By altering the supply of different types of debt, the idea was to "twist" the yield curve. This came to be known as Operation .

Operation Twist has long been considered a failure. Early studies found little impact on yields, vindicating those who argued that the price of a security depends only on expectations--of inflation, for example, or monetary policy--not its relative supply. Eric Swanson, an economist at the Federal Reserve Bank of San Francisco, disagrees. Previous studies, he reckons, didn't properly isolate the influence of Operation Twist from countervailing factors. By studying the behavior of bonds right around announcements related to Operation Twist, he concludes the programme lowered yields by 15 basis points in total. Since the Fed's current QE programme is comparable in size, at around 4% of total Treasury and agency-backed debt, he reckons it should have the same sort of impact. (The actual effect is difficult to discern; yields have actually risen since QE began, but that is mostly because the economy has improved.)

What that implies is that finance ministries could conduct their own QE by issuing less long-term debt, reducing its supply and driving up prices. In fact, governments have done exactly the opposite. Since mid-November America's Treasury has issued some $589 billion in extra long-term debt, of which the Fed has bought $514 billion. From early 2009 through to March 2010 Britain's Treasury issued Pounds 247 billion ($396 billion) of extra long-term gilts, of which the Bank of England bought Pounds 199 ...