Quantitative easing (QE) is an unconventional monetary policy used by central banks to stimulate the national economy when conventional monetary policy has become ineffective. A central bank implements quantitative easing by buying financial assets fromcommercial banks and other private institutions with newly created money, in order to inject a pre-determined quantity of money into the economy. This is distinguished from the more usual policy of buying or selling government bonds to keep market interest rates at a specified target value. Quantitative easing increases the excess reserves of the banks, and raises the prices of the financial assets bought, which lowers their yield.
Expansionary monetary policy typically involves the central bank buying short-term government bonds in order to lower short-term market interest rates (using a combination of standing lending facilities and open market operations).However, when short-term interest rates are either at, or close to, zero, normal monetary policy can no longer lower interest rates. Quantitative easing may then be used by the monetary authorities to further stimulate the economy by purchasing assets of longer maturity than only short-term government bonds, and thereby lowering longer-term interest rates further out on the yield curve.
Quantitative easing can be used to help ensure inflation does not fall below target. Risks include the policy being more effective than intended in acting against deflation – leading to higher inflation, or of not being effective enough if banks do not lend out the additional reserves.
Ordinarily, a central bank conducts monetary policy by raising or lowering its interest rate target for the inter-bank interest rate. A central bank generally achieves its interest rate target mainly through open market operations, where the central bank buys or sells short-term government bonds from banks and other financial institutions. When the central bank disburses or collects payment for these bonds, it alters the amount of money in the economy, while simultaneously affecting the price (and thereby the yield) for short-term government bonds. This in turn affects the interbank interest rates.
If the nominal interest rate is at or very near zero, the central bank cannot lower it further. Such a situation, called a liquidity trap, can occur, for example, during deflation or when inflation is very low. In such a situation, the central bank may perform quantitative easing by purchasing a pre-determined amount of bonds or other assets from financial institutions without reference to the interest rate. The goal of this policy is to increase the money supply rather than to decrease the interest rate, which cannot be decreased further. This is often considered a "last resort" to stimulate the economy.
Quantitative easing, and monetary policy in general, can only be carried out if the central bank controls the currency used. The central banks of countries in the Eurozone, for example, cannot unilaterally expand their money supply, and thus cannot employ quantitative easing. They must instead rely on the European Central Bank (ECB) to set monetary policy.
The US Federal Reserve held between $700 billion and $800 billion of Treasury notes on its balance sheet before the recession. In late November 2008, the Fed started buying $600 billion in Mortgage-backed securities (MBS). 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. Further purchases were halted as the economy had started to improve, but resumed in August 2010 when the Fed decided the economy was not growing robustly. After the halt in June holdings started falling naturally as debt matured and were projected to fall to $1.7 trillion by 2012. The Fed's revised goal became to keep holdings at the $2.054 trillion level. To maintain that level, the Fed bought $30 billion in 2–10 year Treasury notes a month. In November 2010, the Fed announced a second round of quantitative easing, or "QE2", buying $600 billion of Treasury securities by the end of the second quarter of 2011.
The expression "QE2" became a "ubiquitous nickname" in 2010, usually used to refer to a second round of quantitative easing by central banks. In retrospect, the round of quantitative easing preceding QE2 may be called "QE1". Similarly, "QE3" refers to proposals for an additional round of quantitative easing following QE2. QE3 was announced today!
According to the IMF, the quantitative easing policies undertaken by the central banks of the major developed countries since the beginning of the late-2000s financial crisis have contributed to the reduction in systemic risks following the bankruptcy of Lehman Brothers. The IMF states that the policies also contributed to the improvements in market confidence and the bottoming out of the recession in the G-7 economies in the second half of 2009.
Former Federal Reserve Chairman Alan Greenspan calculated that as of July 2012 there was "very little impact on the economy" and noted "I'm very surprised at the data."
Economist Martin Feldstein argues that QE2 led to a rise in the stock-market in the second half of 2010, which in turn contributed to increasing consumption and the strong performance of the US economy in late-2010.
In November 2010, a group of conservative Republican economists and political activists released an open letter to Federal Reserve Chairman Ben Bernanke questioning the efficacy of the Fed's QE program. The Fed responded that their actions reflected the economic environment of high unemployment and low inflation.
Quantitative easing may cause higher inflation than desired if the amount of easing required is overestimated, and too much money is created. On the other hand, it can fail if banks remain reluctant to lend money to small business and households in order to spur demand. Quantitative easing can effectively ease the process of deleveraging as it lowers yields. But in the context of a global economy, lower interest rates may contribute to asset bubbles in other economies.
An increase in money supply has an inflationary effect (as indicated by an increase in the annual rate of inflation). There is a time lag between money growth and inflation, inflationary pressures associated with money growth from QE could build before the central bank acts to counter them. Inflationary risks are mitigated if the system's economy outgrows the pace of the increase of the money supply from the easing. If production in an economy increases because of the increased money supply, the value of a unit of currency may also increase, even though there is more currency available. For example, if a nation's economy were to spur a significant increase in output at a rate at least as high as the amount of debt monetized, the inflationary pressures would be equalized. This can only happen if member banks actually lend the excess money out instead of hoarding the extra cash. During times of high economic output, the central bank always has the option of restoring the reserves back to higher levels through raising of interest rates or other means, effectively reversing the easing steps taken.
On the other hand, in economies when the monetary demand is highly elastic with respect to interest rates, or interest rates are close to zero (symptoms which imply a liquidity trap), quantitative easing can be implemented in order to further boost monetary supply, and assuming that the economy is well below potential (inside the production possibilities frontier), the inflationary effect would not be present at all, or in a much smaller proportion.
Increasing the money supply tends to depreciate a country's exchange rates versus other currencies. This feature of QE directly benefits exporters residing in the country performing QE and also debtors whose debts are denominated in that currency, for as the currency devalues so does the debt. However, it directly harms creditors and holders of the currency as the real value of their holdings decrease. Devaluation of a currency also directly harms importers as the cost of imported goods is inflated by the devaluation of the currency.
The new money could be used by the banks to invest in emerging markets, commodity-based economies, commodities themselves and non-local opportunities rather than to lend to local businesses that are having difficulty getting loans.
Source: http://en.wikipedia.org/wiki/Quantitative_easing#QE1.2C_QE2.2C_and_QE3
