Quantitative easing. We just can’t get beyond this topic can we? To date it remains the single topic I get the most reader questions about. In response to a recovery that first started to stagnate before the financial crisis was even really over, we got QE1. That ended and the economy started to struggle again. So we got QE2. That still wasn’t quite enough so instead we got Operation Twist. Now we’re again getting sluggish so people think QE3 is coming. But what’s it all mean?
I’ve covered these topics in various forms before:
But I’m not going to force you to reread those posts. Let’s start at the beginning and keep it as simple as possible.
Say the economy is sluggish. The Federal Reserve has many tools to help stimulate the economy. They do this mainly by adjusting interest rates. If interest rates are lower, people have a greater incentive to borrow, be it consumers or businesses. Back in the real world the Fed did this, they pushed their interest rates down to basically 0%.
But it’s not enough. So what to do? Well all the banks have basically stopped lending because they held all those crappy mortgages. So the Fed decides to initiate quantitative easing. Basically they go into the marketplace and purchase mortgage backed securities and other debt. This frees up the banks with more cash and less bad loans on their books, Safer banks provide more stability and can lend more. The moves will also drive down interest rates further. But….
It wasn’t enough. So on to QE2. The Fed decides to take all the interest income of the assets they purchased, plus some more, and buy more assets. So they take more bad debt off the market, and buy government issued bonds. This drives interest rates down further, mostly longer term rates like 10 and 30 year terms. But….
It’s still not enough. The economy is recovering, but still not healthy. On to Operation Twist. Up until this point the Fed has been growing the number of assets they had (sometimes referred to as inflating their balance sheet). But in Operation Twist the Fed sells some of the assets they have with shorter terms and buys more with longer terms. The effect will further drive down long term interest rates (ta da! 3.5% 30 year mortgage). But….
Now we’re in July 2012. Our common economic indicators have started to stagnate. The economy is growing, but slower. We’re adding jobs, but not as quickly as before, and not quickly enough. So the media is drumming up the idea of another stimulus program by the Fed to help the economy move along. One can wonder what else they can do, and there’s no shortage of speculation but that’s all that is out there. As of yet, there is no QE3. And should there be, we won’t know what it looks like until it is announced.
On to some additional detail
How can the Fed afford to buy everything they’ve bought? Where do they get the money. Essentially, they “print” it (don’t let the image fool you, there’s no printing). The Fed will argue this is not what they do but the simplest answer is that because they are the central bank, they have such authority. In addition to trying to influence interest rates, they can also influence the money supply. They two go hand in hand.
This creates its own problems because if an increasing amount of money in the marketplace is chasing after the same quantity of goods and services, inflation occurs. Yet since the financial crisis and despite the dramatic increase in money supply, we have not yet seen this inflation.
So then, we have two rounds of QE, which the Fed tried to not call QE, and Operation Twist. If the economy continues to show signs of weakness, perhaps we’ll see a new program which we could generically call QE3. But let’s hope it’s not necessary.