Ah, quantitative easing, a complex sounding term that is actually quite simple. It’s a term that as of yet has not really filtered it’s way through the traditional media. Perhaps they haven’t taken the time to look it up on Wikipedia or they themselves find the name so daunting assume the definition is impossible to follow.

Whatever the case may be, “quantitative easing” has not found its way out of the business press, and I hope to help change that because it’s actually quite simple. Here’s what Investopedia has to say about quantitative easing:

A government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.

Huh?

Okay, so maybe someone did look it up, found this, and decided to instead rephrase the headline in a more “local paper” friendly format.  But I maintain that quantitative easing is simple.

Imagine a situation in which the economy is at risk of recession.  The Federal Reserve may cut interest rates to give you and me the incentive to borrow money.  But what if that doesn’t work?  Perhaps the banks aren’t willing to lend or despite low rates we aren’t interested in borrowing.  So the Fed cuts rates again and again and again, but it doesn’t work.  Now the rates are near 0% from the Fed and dirt cheap for you and me, but no one is borrowing and the economy is in recession.  What to do?

The Fed has other tools beyond just moving an interest rate around.  One of those tools is quantitative easing.  It’s actually a fancy way of saying, “we’re gonna print money”.  Now don’t quote me on that because that carries a negative connotation; which is why the Fed doesn’t say it that way.  Quantitative easing is a method of injecting money into the economy.

Injecting money into the economy is supposed to stimulate it.  For example, when the federal government does a stimulus program, they either spend money themselves or give it to you to spend.  This money makes its way into the economy and spurs activity, and growth.  Quantitative easing is the Fed’s method of helping.  One way they do this is to buy securities issued by the Treasury (which is then given out in the stimulus).  The Fed can also go straight to banks by purchasing securities (such as mortgage backed securities) off the books of banks.  With the bad loans off the books, the banks have a greater appetite for risk and would be more willing to lend.

If this is sounding familiar it’s because the Fed has already done quantitative easing.  Now they’re going to do it again, but more modestly.  This is because the economy is not growing as fast as we need to see a recovery, and we could slip back into a recession.

Quantitative easing has its risks though.  It increases the amount of money in the system, and with more dollars going after the same goods, inflation usually follows.  But that was the worry two years ago too, and it didn’t happen.  This is a testimateto how stubborn this economy has been.  Inflation will come, but the Fed knows that.  When they see it, you’ll see another term in the business headlines: shrinking the balance sheet.  We’ll come back to that, when the Fed does.

Read: US Federal Reserve Starts QE Lite To Placate Markets

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categories: banking, business, economics, loans