A central bank’s biggest tool to stimulate the economy is reducing the interest rate. When the interest rate is at or near zero and economic growth is still too slow, is there anything else that can be done? That is where quantitative easing comes in.
In the United States, we have been pursuing an expansionary monetary policy to grow the economy. But with interest rates near zero and our economy still struggling, there not much else the Federal Reserve can do that can have much of an impact except extraordinary measures like quantitative and credit easing.
So what exactly is quantitative easing?
It is an action of last resort by the Federal Reserve to stimulate our sluggish economy. Instead of buying varying amounts of government bonds from banks and other financial institutions from time to time, the central bank commits to buying an amount of pre-determined amount of bonds, and therefore adds stability and predictability to its efforts to increase the monetary base.
To be effective, the amount of quantitative easing has to be so large, that the banks and financial institutions selling the bonds will be flooded with so much money that they will have no choice but to lend or invest it.
How large? The Federal Reserve held over $700 billion of Treasury notes on its balance sheet before the 2008 financial crisis. QE1 ballooned Treasury note holdings to $2.1 trillion, QE2 added another $600 billion, QE3 adds $40 billion per month since September 2012, and QE4 increases QE3 to $85 billion per month since December 2012.
And what is credit easing?
Credit easing is where the Federal Reserve increases the monetary base by buying private sector assets like corporate bonds and residential mortgage-backed securities in contrast to quantitative easing where the Federal Reserve buys government bonds. The Federal Reserves increases the money supply directly to companies and households, which it did in 2010 by buying $1.25 trillion of mortgage-backed securities.
There is very little question that quantitative and credit easing has increased the money supply by trillions of dollars, which have contributed to stabilizing our country’s financial system. However, the trick will be how to unwind the quantitative and credit easing programs without harming very fragile economic growth. The Federal Reserve will eventually want to sell the government bonds and mortgage-backed securities back to the private sector. Depending on their sales and prices fall short, the difference will have to be monetized, and therefore could lead to inflation. And given the magnitude of dollars, it will take a long time sell.
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