Definition: Quantitative easing (QE) is the Federal Reserve's program of buying bonds from its member banks. The Fed purchases U.S. Treasury notes and mortgage-backed securities (MBS), and issues credit to the banks' reserves to buy the bonds. The purpose of this expansionary monetary policy is to lower interest rates and spur economic growth.
Where does the money come from to purchase these assets? The Fed has the ability to simply create it. This unique ability is a function of all central banks. It has the same effect as printing money. The asset purchases are done by the Trading Desk at the New York Federal Reserve Bank.
Quantitative easing is a massive expansion of the Fed's normal open market operations. Even before the recession, the Fed held between $700-$800 billion of Treasury notes on its balance sheet, varying the amount to tweak the money supply. However, as a result of QE, the Fed's balance sheet has more than quadrupled, to $4 trillion. That makes QE the most massive economic stimulus program in world history.
Quantitative Easing Explained
How does quantitative easing work? The Fed adds credit to the banks' reserve accounts in exchange for MBS and Treasuries. The reserve account is the amount that banks must have on hand each night when they close their books. The Fed requires that around 10% of bank deposits be held either in cash in the banks' vaults or at the local Federal Reserve bank. For more, see Reserve Requirement.
When the Fed adds credit, the banks have more than they need in reserves. They now have more to lend to other banks. As banks try to unload their extra reserves, they drop the interest rate they charge. This is known as the Fed funds rate. This rate is the basis for all other interest rates. (Source: Federal Reserve Bank of San Francisco, What are the tools of U.S. monetary policy?)
QE increases the money supply because lower interest rates allow banks to make more loans. Bank loans stimulate demand by giving businesses more money to expand, and shoppers more credit to buy things with.
Quantitative easing stimulates the economy in another way. The Federal government auctions off large quantities of Treasuries to pay for expansionary fiscal policy. As the Fed buys Treasuries, it increases demand, keeping Treasury yields low. Since Treasuries are the basis for all long-term interest rates, it also keeps auto, furniture and other consumer debt rates affordable. The same is true for corporate bonds, allowing businesses to expand more cheaply. Most important, QE keeps long-term, fixed-interest mortgage rates low. And that's important to support the housing market.
QE1 (December 2008 - June 2010)
On November 25, 2008, the Fed announced it would purchase $800 billion in bank debt, MBS, and Treasury notes from member banks. It ended up buying much more that that. It bought $175 million in MBS that had been originated by Fannie Mae, Freddie Mac, or the Federal Home Loan Banks, and $1.25 trillion in MBS that had been guaranteed by the mortgage giants. Initially, the purpose was to help banks by taking these subprime MBS off of their balance sheets. In less than six months, this aggressive purchasing program had more than doubled the central bank's holdings. Between March and October 2009, the Fed also bought $300 billion of longer-term Treasuries, such as 10-year notes.
The Fed halted purchases in June 2010 because the economy was growing again. Just two months later, the economy started to falter, so the Fed renewed QE1. It bought $30 billion a month in longer-term Treasuries to keep its holdings at around $2 trillion.
Its other tools of expansionary monetary policy were also maxed out. The discount rate was near zero. The Fed even paid interest on banks' reserves. For more, see QE1.
QE2 (November 2010 - June 2011)
On November 3 2010, the Fed announced it would increase quantitative easing, buying $600 billion of Treasury securities by the end of the second quarter of 2011. This second round of easing was known as QE2. The Fed was actually hoping to spur inflation a bit by increasing the money supply. Expectations of inflation increase demand, which would spur economic growth. That's because people are more likely to buy consumer products now if they know prices will be higher in the future. For more, see The Federal Reserve's Quantitative Easing 2.
Operation Twist (September 2011 - December 2012)
In September 2011, the Fed launched Operation Twist. This was similar to QE2, with two exceptions. First, as the Fed's short-term Treasury bills expired, it bought long-term notes. Second, the Fed stepped up its purchases of MBS. Both "twists" were designed to support the moribund housing market. For more, see What Is Operation Twist?.
QE3 (September 2012 - Present)
On September 13, 2012, the Fed announced QE3. It agreed to buy $40 billion in MBS, and continue Operation Twist, adding a total $85 billion of liquidity a month. The Fed did three other things it had never done before:
- It announced it would keep the Fed funds rate at zero until 2015.
- It said it would keep QE in place until jobs improved "substantially."
- The Fed acted to boost the economy, not avoid a contraction. (Source: CNBC, Three Things the Fed Did Today It's Never Done Before, September 13, 2012)
For more, see What Is QE3?.
QE4 (January 2013 - Present)
In December 2012, the Fed announced it would buy a total of $85 billion in long-term Treasuries and MBS. It ended Operation Twist, instead just rolling over the short-term bills. It clarified its direction by promising to keep QE4 until one of two conditions were met: either unemployment fell below 6.5% or inflation rose above 2.5%. Since QE4 is really just an extension of QE3, some people just refer to it as QE3. Other refer to it as "QE Infinity" because it doesn't have a definite end date. For more, see QE4 and Fed's QE4 Buys Time for Fiscal Cliff Resolutions.
On December 18, the FOMC announced it begin tapering its purchases, as its three economic targets were being met: The unemployment rate was at 7%, GDP growth was at least 2-3%, and the core inflation rate hadn't exceeded 2%.The FOMC would keep the Fed funds rate and the discount rate between zero and 1/4 points until 2015, and below 2% through 2016. For the latest updates, see FOMC Meetings.
This followed Ben Bernanke's announcement on June 19 that the Fed was considering tapering. This threw bond investors into a panicked selling spree. As demand for bonds fell, interest rates spiked 75% in three months. As a result, the Fed held off the actual taper until December, giving the markets a chance to calm down. For more, see FOMC Announces QE Taper Could Begin Later This Year. (Sources: Federal Reserve Bank of St. Louis, Financial Crisis Timeline; Federal Reserve, Open Market Operations)
DId QE Work?
QE achieved some of its goals, missed others completely, and may have created a bubble. First, QE did remove toxic subprime mortgages from banks' balance sheets, restoring trust and therefore banking operations. Second, it also helped to stabilize the U.S. economy, providing the funds and the confidence to pull out of the recession. Third, it kept interest rates low enough to revive the housing market. Fourth, it did stimulate economic growth, although probably not as much as the Fed would have liked.
However, it didn't achieve the Fed's goal of making more credit available. It gave the money to banks, which basically sat on the funds instead of lending it out. Banks used the funds to triple their stock prices through dividends and stock buy-backs. The large banks also consolidated their holdings, so that the largest .2% of banks control more than 70% of bank assets. Since banks didn't lend out the money, inflation wasn't created in consumer goods. As a result, the Fed's measurement of inflation, the CPI, stayed within the Fed's target. (Source: WSJ, Confessions of a Quantitative Easer, November 12, 2013)
However, QE did create asset inflation, first in gold and other commodities, and then in stocks, as investors were forced out of bonds. An ounce of gold more than doubled, rising from $869.75 to $1,895 between 2008 and 2011. After that, investors shifted to stocks. The Dow rose 24% in 2013 as corporations followed the banks' example and boosted stock prices with buybacks and dividends. Article updated February 27, 2014