Quantitative Easing 101
Quantitative Easing (QE) are the latest buzz words in the financial
markets. It is important to become intimately comfortable with these
words because they will be the catch phrase of 2009 thanks to the
latest interest rate cuts by the Federal Reserve and the Bank of Japan.
What is Quantitative Easing?
Quantitative Easing is a monetary policy tool that central banks use
when they run out of room to cut interest rates. The word
"Quantitative" refers to the money supply and easing money supply means
to increase it. For many people, this term is new and with good reason
because it was only coined by the Bank of Japan in 2001 after they took
interest rates to zero. When that happened, they obviously had no more
room to cut rates, which made Quantitative Easing their Plan B.
Quantitative Easing basically involves printing money to buy a
variety of securities with the end goal of flooding the financial
markets with cash or liquidity. By doing so, it increases the amount of
currency in circulation which reduces the value of the currency and
boosts inflation. A good way to look at this is if there were only 100
signed Babe Ruth baseball cards worth $1000 each in the world and all
of a sudden another 1000 signed baseball cards were discovered, then
you would expect each baseball card to now be worth a lot less. Having
more baseball cards in the market at lower prices hopefully spurs more
activity in the baseball card market. In many ways, the goal of
Quantitative Easing is the same. By the flooding the market with
liquidity, the central bank aims to promote lending and prevent a
shortage in the future. Of course Quantitative Easing is much more
involved than baseball card trading.
What Outcome Can Be Expected from Quantitative Easing?
Granted that Quantitative Easing has only ever been implemented once
in Japan, there is not much precedent. However with that in mind, we
are sure that the Fed analyzed the outcome of Japan's zero interest
rate policy before bringing US interest rates within a whisker of
Japan's 2000 levels.
The Bank of Japan embarked upon this new concept in monetary
economics in its effort to fight a frustrating period of economic
stagnation and decline in 2001 which lasted until 2006. With rates at
0% the central bank was forced to implement some new level of policy to
fight the wave of deflation that had plagued the country. Deflation,
another renewed catch-word in today's economic climate, is an overall
decline in prices over an extended period of time. We are all familiar
with how disastrous an inflationary state can be on an economy,
unfortunately deflation is no different. The cause of the phenomenon is
when consumers become so resistant to spending that sellers are forced
to continuously cut prices. In Japan, the BoJ accomplished their easing
targets by expanding the limits as to the types of securities that they
would purchase; for instance buying long-term treasuries, asset-backed
securities, equities, and new levels of commercial paper. This is all
in an effort to flood the financial system with so much excess reserves
and liquidity that they would be forced to resume normal lending
In the first year of Quantitative Easing, USD/JPY rose 18.5 percent.
This means that the Japanese Yen weakened against the US dollar, which
is a textbook reaction to Quantitative Easing. The Nikkei also dropped
28 percent. Between 2002 and the end of 2004, USD/JPY fell 22 percent
as the Japanese economy began to stabilize. During that same time the
Nikkei recovered 20 percent, but not before it fell another 20 percent.
Although it has been heavily debated whether Quantitative Easing drove
the turnaround in the economy, most people agree that it put a halt to
Fed's Version of Quantitative Easing
With US interest rates pretty much at zero, the Federal Reserve has
informally adopted its own version of Quantitative Easing. Some people
may even argue that the Fed has been pursuing this strategy for months
now. In conjunction with the Treasury department, the Fed has doubled
their balance sheet in the past 3 months to more than $2 trillion. They
have done this by purchasing direct equity investments in banks, easing
standards on commercial paper purchases, made efforts to relieve
institutions of their toxic asset-backed securities and is now
considering buying Treasury bonds and agency debt. By buying these
assets, they are adding money into the financial system. Like the Yen,
Quantitative Easing exposes the US dollar to significant downside
risks, but it is also the step that the central bank needs to take to
stabilize the US economy and to prevent a deflationary spiral.