Posted in Finance Articles, Total Reads: 1507
, Published on 26 June 2013
The term Quantitative Easing (QE) is a form of monetary policy that central banks use so as to increase the supply of money in an economy. It is done when the bank interest rate, discount rate and/or interbank interest rate are at near zero level. The Central bank first credits its own account with money it has created ex nihilo ("out of nothing") followed by purchases of financial assets, including government bonds, corporate bonds, from banks and other financial institutions in via open market operations. The process in turn gives banks excess reserves by way of deposit multiplication and leads to increase in money supply thus stimulating the economy.
Central banks Reason for undertaking Quantitative Easing
Keeping interest rate low is not enough to maintain an adequate money supply in certain situations so quantitative easing is employed to increase the money supply in the financial system.
The increase in reserves of banks which allows them to lend more and even buy bank bonds from the central bank itself. This has the effect of lowering government bonds yields and similar investments, making it cheaper for business to raise capital.
A third reason is the investors will be able to swap investments in financial assets like shares and bonds and thus enable them to increase their portfolio wealth and reduce risk. Quantitative Easing can also help in reducing interbank overnight interest rates.
We try to understand whether Quantitative easing is a boon or a bane by looking at QE done by the Federal Reserve and its impact. We use Fed QE1 as it was the most significant of all the major central bank’s QE in terms of the magnitude of bond purchases throughout the entire period except late 2011.
Liquidity and interest rates:
Prior to Fed QE1 Banks with excess liquidity were not willing to lend to those requiring the same even at premiums leading to a credit crunch. However after Fed QE1 the signalling of lower interest rates for the future and increasing reserve balances of banks created liquidity in the market.
Flows into Emerging markets
Fed QE1 not only impacted the U.S economy but also led to flows outside US, into emerging markets. Using data from EPRF we found that the sentiment in emerging markets picked up. EPFR Global which tracks aggregate flows into all mutual funds that invest in local currency debt and equities of Ems showed that a 1% increase in Fed’s assets led to a 0.92% increase in EM equity funds assets during QE1.
Fed QE and Monthly U.S. Unemployment
The unemployment rate in the U.S was climbing prior to Fed QE1. When QE1 started in Dec 2008, the unemployment rate remained sticky between 8.3 to 9.5 levels. Thereafter, unemployment began to gradually decline, coinciding with the time period when Fed QE2 took place between Nov 2010 and June 2011. It is possible that the drop in the unemployment rates to lower levels can be attributed to QE as well as other fiscal measures taken by the U.S Government.
QE has blamed to have set off rising inflationary expectations. This is because QE increases money supply leading to increased ability of individuals and firms to spend, which in turn leads to demand-driven inflation.
Rise in asset prices:
Another negative seen which is in a way related to inflation is the prices of global commodities. Both gold and crude oil have been rising. A study done by me indicated that Gold prices start to price in QE even before the actual announcement Crude Oil (Brent) pricing lags by three months
Finally, QE can neither be characterised as a blessing or a curse. During the crisis of 2008, Fed QE, i.e. QE1 was used as a tool to combat deflation, deceleration in growth rate, tight credits markets and rising interest rates and bring about stability. However not every solution can be a perfect one especially in such an uncertain landscape. Thus the benefits of QE come at the cost of inflation and rising global asset prices.
This article has been authored Erica Fernandes from K.J.Somaiya Institute of Management Studies & Research
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