Quantitative Easing

Topics: Reserve currency, Central bank, Federal Reserve System Pages: 13 (4947 words) Published: January 18, 2012
Evan Schrager 11/14/2011
Quantitative Easing Research Paper
The term quantitative easing (QE) describes a process in which the Federal Reserve expands its balance sheet through purchasing back government bonds from financial institutions with electronically created funds. The government purchases, by way of account deposits, give banks the excess reserves required for them to create new money by the process of deposit multiplication from increased lending in the fractional reserve banking system. As the supply of medium and long-term government bonds decreases, their prices increase. This leads to a decrease in their yield; yields are often a determinant of long-term interest rates, mortgages and most business lending. Since it is easier for individuals to borrow money, consumer wealth increases, which leads to investment and consumption increases as well. Risks include the policy being more effective than intended, spurring hyperinflation, or the risk of not being effective enough, if banks opt simply to pocket the additional cash in order to increase their capital reserves in a climate of increasing defaults in their present loan portfolio. In the quantitative easing process, the Fed goes to a network of dealers, in search of Treasury bonds. The Fed buys the bonds in a competitive bidding process between the approved bond dealers. The Fed takes a bond certificate and gives the dealers freshly printed US dollars. The transactions are done electronically, but it is still referred to as printed money. The US Federal Reserve held between $700 billion and $800 billion of Treasury notes on its balance sheet before the current recession. In late November 2008, the Fed started buying $600 billion in Mortgage-backed securities. By March 2009, it held $1.75 trillion of bank debt, MBS, and Treasury notes, and reached a peak of $2.1 trillion in June 2010. The primary dealers can offer to sell the Fed bonds held by their clients. The newly printed money moves from the Fed, to the dealer, to the client’s brokerage account. Cash is moving directly into the real economy. The customer can buy another bond, buy stocks, use it at the grocery store, or simply keep the cash. Right now, however, cash is earning next to nothing, so investors are motivated to find alternative stores of value. They are motivated to spend or invest their cash. With an ongoing battle taking place between inflationary and deflationary forces in the economy and financial markets, it is extremely important for investors to understand how “quantitave easing” programs will impact their investments and their long term purchasing power. Since quantitative easing represents a threat to our wealth based on its potential adverse impact, this topic warrants serious attention above and beyond a boilerplate analysis. Common references to “cash sitting at banks” will give investors a poor read on what quantitative easing is and the possible ramifications for our portfolios and the economy. In order to put QE in context, I will discuss the Japanese deflationary spiral of the ‘90s. Japan suffered from stagflation throughout the 1990’s, so the Bank of Japan instituted a quantitative easing program of its own, referred to as QEP. The QEP consisted of three key elements: “(1) The BOJ changed its main operating target from the uncollateralized overnight call rate to the outstanding current account balances (CABs) held by financial institutions at the BOJ (i.e., bank reserves), and ultimately boosted the CAB well in excess of required reserves.

(2) The BOJ boosted its purchases of government bonds, including long-term JGBs, and some other assets, in order to help achieve the targeted increases in CABs.

(3) The BOJ committed to maintain the QEP until the core CPI (which in Japan is defined to exclude perishables but not energy) stopped declining.”

The effect of the Bank of Japan’s liquidity injections on bank lending was muted by the substitution of central...

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