Understanding Quantitative Easing

by Jason Jenkins

Understanding Quantitative Easing (QE)

There are some economists – most can be called Keynesian – who believe in times of economic hardship, you need something to get more money circulating around the economy.

To do this, your choices are limited. The first is for direct government intervention. Think the Great Depression. More recently, look toward infrastructure projects in the economic stimulus package passed in 2009. The government creates jobs and pays people directly, putting money in their pockets.

I did mention the stimulus package from a few years back. That legislation didn’t work as promised and the word stimulus has become blasphemous up in D.C.

Another option is for the Federal Reserve to cut interest rates, which makes it cheaper to borrow. The idea is for people to borrow more from banks so they will consume, build and create more.

Fed Chair Ben Bernanke did that back in 2008, but no one is biting. In fact, the Fed lowered interest rates all the way down to zero, so it’s safe to say there’s no more wiggle room for that option.

So with the initial tried and true options ineffective, the Fed borrowed a page from Japan’s monetary bank that they implemented a decade ago when faced with a similar financial crisis. It’s called quantitative easing, and not too many ideas have rivaled it as far as sparking controversy.

What Exactly is Quantitative Easing?

Quantitative easing (QE) is monetary policy used by central banks to increase the supply of money in an economy when the bank interest rate, discount rate or interbank interest rate is either at, or close to, zero.

A central bank does this by first crediting its own account with money it has “created,” or printed. It then purchases financial assets such as government bonds and corporate bonds, from banks and other financial institutions. The purchases, by way of account deposits, give banks the excess reserves required for them to create new money from increased lending in the fractional reserve banking system. The increase in the money supply thus stimulates the economy.

Potential Problems With QE

  • Risks include the policy being more effective than intended, spurring inflation. In order for the Fed to purchase these assets, they have to print more money. Printing more money eventually lowers the value of the dollar.
  • Banks have the ability to just pocket this new infusion of cash so they can increase their capital reserves in a climate of increasing defaults in their present loan portfolio.
  • Piggy-backing on the last point, a de-valued dollar down could drive up the cost of commodities. This could cause a big problem where the average consumer pays more for basic essentials like wheat, sugar, coffee and pork, just to name a few. If the prices we pay for essentials rise, the stimulation of the economy is offset by higher costs.

And What Does Quantitative Easing Do to Markets?

There’s a reason that markets usually react favorably to QE rumors and implementation.

QE attempts to flood the global financial markets with fresh cash to buffer deflated asset prices. When the stock market goes up, people and businesses feel wealthier, and are thus more apt to spend, invest and, hopefully, take more risks. Rising asset prices can improve the asset side of impaired global balance sheets, which the Fed hopes can rekindle the wealth effect. If the Fed can boost asset prices, balance sheets become more attractive in terms of the ratio of assets to liabilities.

But in this time of uncertainty, take into account the possible downsides of a possible QE3. Cause if the bubble bursts, there will be grave consequences. In the end, growth needs concrete private sector investment to carry on.

Good Investing,

Jason Jenkins

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