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What Is QE1?

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quantitative easing

Fed Chair Ben Bernanke

Photo:Win Mcnamee/Getty
Definition: QE1 is the nickname given to the Federal Reserve's initial round of quantitative easing. That's when the Fed purchases debt, such as mortgage-backed securities (MBS), consumer loans and Treasury bills, bonds and notes. It usually purchases them from its member banks through its Trading Desk at the New York Federal Reserve Bank. The Fed has the authority to create credit out of thin air, allowing it to purchase as much as it wants, anytime it wants. It has this awesome ability so it can quickly pump liquidity into the economy as needed.

The QE1 program purchases lasted from December 2008 until March 2010. There were additional transactions made from April-August 2010 to facilitate the settlement of the initial purchases.

QE1 was launched on November 26, 2008, when Fed Chairman Ben Bernanke announced an aggressive attack on the financial crisis of 2008. The Fed began buying $600 billion in MBS, and $100 billion in other debt, all of which were backed by Fannie Mae, Freddie Mac, Ginnie Mae and the Federal Home Loan Banks. The purpose was to support the housing market, which was devastated by the subprime mortgage crisis.

The following month, the Fed cut its Fed funds rate and its discount rate to zero. The Fed even began paying interest to banks for their reserve requirements. As a result, all of the Fed's most important expansionary monetary policy tools had now reached their limits. Therefore, quantitative easing became the central bank's primary tool to boost economic growth. For more, see Fed's $800 Billion Plan Lowers Mortgage Rates, November 27, 2008)

By March 2009, the Fed's portfolio of securities had reached a record $1.75 trillion. Nevertheless, the central bank continued to expand QE1 to fight the recession, which had gotten worse. It announced it would buy $750 billion more in MBS, $100 billion in Fannie and Freddie debt, and $300 billion of longer-term Treasuries over the next six months. (Source: Bankrate.com, QE1 Timeline)

By June 2010, the Fed's portfolio had expanded to an alarming $2.1 trillion. Further purchases were halted since the economy had started to improve. Holdings started falling naturally as the debt matured. In fact, holdings were projected to fall to $1.7 trillion by 2012.

Despite QE1, Banks Weren't Lending

However, just a few months later (August), hinted that the Fed might resume QE because the economy wasn't growing robustly. Why not? Banks still weren't lending as much as the Fed had hoped. Instead, they were hoarding the cash, using it to write down the rest of the subprime mortgage debt they still had on their books. Others were increasing their capital ratios, just in case.

Many banks complained that there just weren't enough credit-worthy individuals and companies to lend to. Perhaps that was because they'd also raised their lending standards. For whatever reason, the Fed's QE1 program looked a lot like pushing a string. The Fed couldn't force banks to lend, so it just kept giving them incentives to do so.

Did QE1 Work?

QE1 had some major drawbacks, but it did work overall. The first problem, as mentioned, was that it was not effective in forcing banks to lend. If the $1 trillion or so that the Fed had pumped into banks had been lent out, it would have boosted the economy by $10 trillion. That's because a bank typically only has to keep 10% of its total assets in reserve. That's known as the reserve requirement. It can lend the rest, which then gets deposited in other banks. They only keep 10% in reserve, lending the rest. That's how $1 trillion in Fed credit can become $10 trillion in economic growth. Unfortunately, the Fed didn't have the authority to make the banks lend it, and so it didn't really work as anticipated.

That led to the second problem -- the Fed now had a record-high level of potentially bad assets on its balance sheet. Some experts became concerned that the subprime mortgage crisis was merely transferred to the Fed, which might then be crippled by it just like the banks were. However, the Fed's ability to create cash to cover any toxic debt is unlimited.

This, of course, leads to the third problem with quantitative easing. At some point it could create inflation, or even hyperinflation. That's because the more dollars the Fed creates, the less valuable existing dollars are. Over time, this lowers the value of all dollars, which then can buy less. The result is inflation.

However, the Fed was actually trying to create a mild inflation. That's because it was counteracting deflation in housing, where prices had plummeted 30% from their peak in 2006. The Fed was dealing with the immediate crisis, and wasn't worried about inflation. Why? Because inflation doesn't usually occur until the economy is growing robustly. That's a problem the Fed would welcome. At that time, the assets on the Fed's books would have increased in value, as well. The Fed would have no problem selling them, which would also reduce the money supply and cool off any inflation.

That's why QE1 was basically a success. It lowered interest rates about a full percentage point, from 6.33% in November 2011 to 5.23% in March 2010 for a 30-year fixed interest mortgage.(Source: Bankrate.com, QE1 Timeline)

These low rates kept the housing market on life support. They also pushed investors into alternatives. Unfortunately, sometimes this included runs on oil and gold, shooting prices sky-high. Nevertheless, record-low interest rates provided the lubrication needed to get the American economic engine cranking again. Article updated 12/21/12

What Came After QE1?

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