Quantitative Easing - The Measured Risk

Posted in Finance Articles, Total Reads: 2991 , Published on 07 November 2011
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Quantitative Easing (QE) is a monetary policy tool used by the central banks to increase the money supply in the market to stimulate an economy in recession and to do away with deflation. "Quantitative" implies creation of specific amount of money and “easing" implies the reduction of pressure on banks.

Quantitative Easing


Quantitative easing is used by the Central bank to increase the money supply in the economy that allows them to increase the reserves of the Banking system. This is typically done by purchase of central government bonds in order to stabilise/increase their prices and thereby lower the interest rates.


Quantitative easing is merited in the following conditions:


• When other measures to increase money supply have failed to achieve the desired impact
• The bank interest rate, discount rate or interbank interest rate are low or close to zero
Central banks generally use a control on interest rates or reserve requirements to influence the amount of money supply in the market. However, in situations like very low inflation or deflation setting a low interest rate cannot help to maintain the money supply desired by the central banks. In such cases quantitative easing is implemented to increase the amount of money in the financial system. This is mostly used as the "last resort" to increase the money supply.


Quantitative Easing was first implemented by the Bank of Japan in 2001 to fight deflation. In the year 2008 QE was implemented by the US Federal reserve to fight the downturn. This came to be known as QE 1. A second round of QE, referred to as QE 2, is now being implemented by the US Federal Reserve, wherein, it has announced the purchase of US $ 600 billion of treasury securities by the middle of 2011. QE was also implemented by Bank of England in the year 2009 wherein it bought 200 Bn Pounds worth of assets between March 2009 and August 2009 to boost economic growth and stave off deflation that had resulted due to pressures exerted by the economic downturn of the year 2008.


How Quantitative Easing works:

• In times of recession, the banks avoid lending to the businesses and also to the other banks. This is because of the lack of confidence in the credit market.

• This results in a sort of a lock-up in the lending cycle.

• To free the market from this lock-up, the central banks cut interest rates to a band of 0-0.25%. This is how the central banks can control the “price” of the credit available. However this might not be sufficient to revive the economy.

• In such cases, when the Bank has cut the short term interest rates to zero or close to zero levels and has not been able to achieve the desired impact, central banks take control of also the quantity of money available in the market. This is termed as “Quantitative Easing.”

• This is done by first crediting central banks’ own account with money that is created ex nihilo, analogous to printing of money.

• This is followed by open market operations like purchase of financial assets, including government bonds and corporate bonds, from banks and other financial institutions

• These funds are then used for "monetising the debt”, in which investments like government bonds are purchased from financial firms such as banks, insurance companies and pension funds. 

• The Central Bank acquires treasury securities which tends to spur bond prices and brings down the interest rates.

• It also buys the riskier assets held by banks such as mortgage backed securities, CDO’s, etc. thereby reducing their risk exposure and increasing their risk appetite.

• These purchases, in the form of account deposits, provide banks the excess reserves required for creating new money by the process of deposit multiplication through increased lending.

• Also, when the yields on bonds fall, the banks, instead of holding bonds, are encouraged to lend this money to public. This is because

• When the banks don’t lend, they buy Government bonds to make money at around 2-5%

• However when the yields have fallen (as a result of open market operations by the Central Bank) there is hardly any incentive for the banks to buy bonds.
• Hence they look towards lending money to businesses and other banks.

The following is the chain of events that is expected to occur:

Therefore, in short, the above mentioned steps by the Central bank are expected to lead to an influx of money into the economy which helps spur economic recovery.
Thus, while during good economic times the monetary base is kept under control to fight inflation the reverse of this technique is employed during real bad times when all other measures to revive the economy have failed. Quantitative easing, in simple words, implies expanding the money supply to make the economy spend more.
Expected effect of Quantitative Easing on the Economy


Benefits:


Quantitative easing can help the economy to ward off recession by offering the following benefits.
1. Interest Rates:
Quantitative easing can help in lowering the longer-term interest rates by bringing down yields to the far end of the yield curve. This is due to increase in bond prices spurred by the purchase of government securities by the central banks
2. Deflation:
Quantitative easing can lower deflationary expectations by keeping interest rates low for a fairly long period and by increasing the money supply.
3. Exports:
Quantitative easing increases the monetary base which in turn shall depreciate the value of the concerned Country’s currency and this shall help stimulate exports.


Concerns/Risks:


Quantitative easing has certain risks as well.

1. Inflation:
Since, the government prints money to buy securities, this decreases the value of money. Generally when quantitative easing is effected inflation is at low levels, but on recovery of economy, the excess money has a potential inflationary risk. If the policy turns out to be more effective than expected it might trigger hyperinflation.
2. Hoarding of excess Cash by Banks:
Another issue is the possibility of hoarding of excess money infused into the banking system and not being loaned out. In a scenario of increasing defaults in their loan portfolio, banks might simply accumulate the additional cash for maintaining their capital reserves.
3. Asset bubbles:
A related concern is that quantitative easing may fuel commodity or housing bubbles. This is due to the fact that quantitative easing may infuse more cash in the economic system than it can actually absorb.
4. Expensive Imports:
While Quantitative increasing decreases the value of the Country’s currency making it export competitive, it makes imports of oil and other essential commodities expensive. Further with fall in the value of currency people will find it less attractive and its value may decline even more.
Conclusion
Quantitative Easing is an approach that does not build an economic recovery on solid financial principles. Rather, the central banks envision an "economic recovery" based on new debt creation.


About the Author

Nidhi Jaipuriya is the student of Narsee Monjee Institute of Management Studies, Mumbai.


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