Quantitative Easing – Life Support for an Economy | Trade Samaritan

Quantitative Easing – Life Support for an Economy

Quantitative easing is an unorthodox mechanism adopted by the Central bank of the country wherein the Government starts buying its own debt (bonds) thereby pushing down the interest rates and borrowing costs

Quantitative easing became a popular strategy after Japan attempted to boost up its economy after a huge financial and economic crash during the 1990s. Up until recently quantitative easing as a monetary policy was being implemented by the Federal Reserve through its eighteen primary dealers on a large scale to uplift the U.S economy.

United States government indulged in this unconventional strategy for over 6 years.

Quantitative easing was introduced in November 2008 till October 2014 in the United States in order to revive itself out of the sub prime crisis and its after effects. Further reading on the sub prime meltdown is available at  http://tradesamaritan.com/articles/sub-prime-meltdown

What is Quantitative Easing?

Under quantitative easing, instead of reducing the rate of interest directly, Central bank attempts to create new money in the economy by buying long term securities. This is mostly done under its bond buying program wherein the Fed starts purchasing the Government bonds and Mortgage bonds from the banks. The Banks and Financial institutions end up receiving money which is kept as reserves and the size of reserve across the banks in the economy swell. The intention of bringing in this money is to encourage banks to lend more and more. So the money which banks now have gets converted into assets on their book. At the bottom line this particular strategy eventually leads to increase in printing of currency. The Federal Reserve or the Central bank pays the bank/Financial institution for the bonds electronically thereby boosting it cash reserve. It is important to note that by its nature electronic money is merely accounting entries. The Quantitative easing does not require a printing press instantly to add money into an injured economy, Central bank creates new money by depositing the bonds proceeds via electronic money in the banks. This activity then triggers the money-multiplier effect i.e willingness and /or ability of banks to lend the money. The aim is to drive down the long term rate of interest hence Central bank chooses to buy long term Government and Mortgage bonds from the banks instead of short term treasury bills.

In a nutshell this is the process and the activity;

QE

Why Quantitative easing?

Mere reduction of interest rate is not enough to boost the economy, one needs to create new money. ‘Willingness to lend’ is always there but in order to complete the picture, ‘ability to lend’  needs to be there as well. The idea behind quantitative easing is that the banks will use the new money generated by selling the bonds to lend to the consumers in order to replace their erstwhile assets (being those bonds sold to the Fed). This phenomenon reduces the interest rates and automatically increases the stock prices and attracts investment and boosts employment. Banks start hankering for borrowers and are willing to lend even at near zero interest rate. Quantitative easing does reduce the unemployment and stabilizes the GDP.

It is interesting to note how this ‘new money’ created by quantitative easing tends to make its way across the world.

Let us understand this with an example

  • In the light of the recession of 2008-09, Bank of China fears the currency risk and decides to get rid of most of its long term U.S treasury bonds by selling these to the U.S. Federal Reserve under their quantitative easing program.
  • Bank of China then receives U.S. dollars in exchange from the Fed.
  • Now Bank of China again fears the currency risk and refuses to hold on to U.S. dollars, and decides to diversify by investing in gold, stocks and emerging market bonds.
  • These investments automatically provide a boost to the respective industry. At the same time the demand for these assets goes up and so does the price of these assets, the simple economics of demand and supply deriving the equilibrium price.

Tapering

Tapering (narrow down) happens when the Central Bank decides to roll back and starts selling the bonds back to the Financial institutions and the banks. Fed starts reversing and backing out from quantitative easing. Tapering in the U.S began in December 2013 and ended in October 2014 with a final $15 billion purchase. There was a lot of anxiety over tapering but the interest rates were adaptive and mostly stayed low. The labor market in the U.S. definitely benefited; the rate of unemployment had shot up severely during the sub prime crisis which dropped considerably right after the Federal Reserve adopted quantitative easing.

Unemployment US

While the U.S. economy presently is at the highest pace (5% annualized growth in Quarter III 2014) since 2003, but the below graph indicates that quantitative easing has not been able to provide a substantial boost to the GDP of the economy. It certainly helped the recovery and brought stability post the 2009 drop but did not lead to any extra ordinary growth, levels are similar to those prior to 2008-09.

us-gdp

Is there a Bubble in the making?

Quantitative easing supports the economy and prevents it from collapsing further however there are quite a few ramifications and this strategy is often criticized by economists. The biggest downside is that it ultimately reduces the value of the currency, poses inflationary risk and reduces the value of savings by lowering the percentage of interest paid on deposits. This is a tool meant to be used in recession and extreme situation but is now being used at all times. This is an artificial life support system and can by no means substitute the free market activity and correction. Quantitative easing implemented by increasing the new money printing and supply creates artificial bubbles domestically as well as internationally. In the need to increase their asset base, the lending institutions develop weak and non-vigilant lending policies. Non-viable and junk businesses tend to flourish along side the healthy ones. Trading of junk bonds and reckless financial transactions tend to shoot up. Consumers do not believe in savings anymore and start borrowing and spending carelessly, all in all quantitative easing pulls the economy out of one bubble only to trap it into yet another bubble.

References:

http://data.bls.gov/

http://www.tradingeconomics.com/

 

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