Quantitative Easing Simplified
You may
have come across this word “Quantitative Easing” and this would have definitely
made you curious about what “Quantitative Easing” is? If this word
“Quantitative Easing” really fascinates you then this is the article that is
made for you.
I have, in
my endeavor, tried to explain the meaning of “Quantitative Easing” in a
complete layman’s language so that the nuances of “Quantitative Easing” can
be crystal clear to all the readers.
“Quantitative
Easing” is a tool deployed by the US Federal Bank (also called as ‘The Fed’) to
counter the Global Economic Meltdown which the entire world witnessed in 2008.
In the wake of low unemployment rates and a complete dysfunctional economy,
‘The Fed’ used this unconventional tool whereby it would create money and
purchase bonds and other financial assets from the commercial banks of their
country to set short term interest rates.
Now you
might be thinking of what would happen when the central bank of USA (‘The Fed’)
start buying bonds and other financial assets from the commercial banks(Like
Bank of America, JP Morgan . Right? Most
certainly this was something that I also thought of.
Here is our
answer...
1. Since ‘The
Fed’ will start purchasing bonds and other financial assets, the commercial
banks will have more cash available to loan. As a result the loan-giving capacity of the banks will
improve and this would, in turn, make it easier to finance projects- for
example, the construction of new offices, new buildings, new bridges. These
projects will then require both skilled and unskilled labour to be worked upon
and therefore the unemployment rates will be reduced, leading to the increase
in National Income and thereby leading to growth of Economy.
2. Moreover,
‘The Fed’ purchases help to drive up the demand for the bonds and given the
supply of bonds, the price of bonds will rise which causes their yield to fall.
Lower yields provide the fuel for economic expansion by lowering borrowers’
cost and hence it would lure them to invest in new avenues and earn more.
My learned readers would be surprised to know that
“Quantitative Easing” is bifurcated into three phases namely QE1, QE2 and QE3
QE1, with the
objective to stimulate the economy, was laid down from the period between
November 25, 2008 to March, 2010 comprising purchases of $600 billion worth of
bonds and other financial assets. But the move had little impact and therefore
the bar was raised to $1.25 billion on 18 March, 2010.
But when
this unconventional move was wrapped up, new form of trouble emerged in the
form of slower growth due to European Debt Crisis which caused renewed
instability in the financial markets.
This made
the then Chairman of US Fed Bank*, Ben Bernanke to further announce the QE2
policy which was spread over the period from November, 2010 to June, 2011 to
achieve a sustainable economy (an economy which can grow without a stimulus).
But this move did little to stimulate growth.
On
September 10, 2012 another round of “Quantitative Easing”, QE3 was launched and this
time the easing was not period-specific but dependant on economic data and
unemployment rates. Observing the move, a singular thing that comes out from
this is ‘The Fed’ view that the economy has not reached a point of self
sustaining growth.
QE3 is also
known as “QE Infinity” under which ‘The Fed’ purchased the following:
ü $85 billion
of Fixed Income Securities per month
ü $40 billion
of Mortgaged-backed Securities per month
ü $45 billion
of US Treasuries per month
US economy
unemployment rate in 2013 was at a five year low of 7% of the labour force. It
is expected to be around 6.3% in 2014 and 5.8% in 2015.
Now both
the unemployment rates becoming low and the economy growing well ‘The Fed’ started
to taper (lessen, reduce) their data driven approach of QE3. They first hinted to
taper on 22 May, 2013 but surprised all by going the other way and decided to
reduce the quantum of purchases only at the end of 2013.
Former
Chairman of ‘The Fed’ announced the first tapering to begin on December 18,
2013 reducing the quantum of purchases as follows:
ü $75 billion
of Fixed Income Securities per month
ü $35 billion
of Mortgaged-backed Securities per month
ü $40 billion
of US Treasuries per month
‘The Fed’
Chairman Ben Bernanke on his second last of his 8 year tenure that is on 29
January, 2014 gave another shock to the emerging markets across the globe by
announcing a further round of tapering which was as follows:
ü $65 billion
of Fixed Income Securities per month
ü $35 billion
of Mortgaged-backed Securities per month
ü $40 billion
of US Treasuries per month
Now you
might be thinking why this tapering will affect the emerging financial markets?
Right... but before going into this let me explain why ‘The Fed’ continued with
its tapering.
The only
reason for this move was that the economy had become strong enough that the
quantum of injection can be reduced and it is expected that ‘The Fed’ will
continue with its tapering and finally phase out the entire stimulus by the end
of 2015 depending on the economic data.
Coming to
the effect of tapering on emerging financial markets, although the policy of “Quantitative
Easing” was meant for the developed economies yet it had an immense affect on
the developing economies. During 2008, the US economy and other developed was
faced with near-zero returns and therefore investors started seeking new and
alternative avenues of investment for higher returns.
Emerging
economies had higher returns and had witnessed a steady growth rate which lured
the investors to invest in these new avenues as they appeared to be a better
alternative to invest.
Therefore,
they started to borrow from US economy in near-zero rates and started to invest
in developing economies like India, China, Argentina and the like. But now
since the US economy has started to perform better (due to "Quantitative
Easing"), the rational investors have started to withdraw their money from the
emerging and developing economies and started to invest their money in
developed economies.
The
detailed effect on TAPERING will be explained in my next blog.
Hope that
this blog has enlightened you on “Quantitative Easing”.
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*The
current Chairman of US Federal Bank is Janet Yellen. She was appointed by the
President of USA on February 1, 2014.
