What is quantitative easing?

Jul 17, 2009

numbers-150What your college econ class might have missed.

In normal times monetary authorities manage monetary policy through the manipulation of the federal funds rate, the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.  By setting that rate, the central bank is able to affect indirectly the volume of lending these institutions make to the economy. A lower rate makes it easier for banks to lend out money and borrow from the federal funds market in order to fulfill their reserve requirements (i.e., the money that they have to keep as reserves by law).  In a period of economic slowdown the Federal Reserve will lower the rate in order to induce banks to lend more.

In some extreme situations however, even with very low fed funds rates (as with the nearly zero percent rates now), banks will not lend. This was the case with Japan in the late 1990s and with the US and UK in the current crisis. When manipulating the price of money does not work, the authorities can turn to what is termed ‘quantitative easing.’  (A good interactive explanation is provided by the Financial Times.) This is an unorthodox form of monetary policy whereby the monetary authorities intervene more directly in the credit intermediation process. They can do this in several ways. First, the authorities can create money and buy assets directly from the banks. If the banks are able to offload some of the lower quality assets they hold, they may be freer to lend. (Willem Buiter suggests the term ‘qualitative easing’ to distinguish this sort of activity from others.)  Second, the authorities can directly purchase long term corporate securities, thereby being a lender to the real economy themselves. They can also buy U.S treasuries, lowering the yield on these safe assets and inducing banks to lend to the real economy rather than the US Government.

The major concern about quantitative easing is that if, despite such attempts, the economy does not pick up, there is now a large additional amount of money in the system. In such a scenario there will be an spike in inflation--and, according to some observers, even the possibility of hyperinflation.

*Updated 2.25.11.

Who is talking about it?

Economist Randall Wray has written about quantitative easing, otherwise known as "QE2", in relation to Fed responses to ongoing economic crisis in 2010. He believes it to be the wrong approach. See "QE2 Won't Save Our Sinking Ship".

Roosevelt Institute Senior Fellow and ND20 columnist Marshall Auerback discussed quantitative easing on Bloomberg here. In his view, the strategy doesn't sufficiently increase aggregate demand and is therefore not an effective way to stimulate the economy. For more on his view, see "Main Street Dying by a Thousand Cuts".

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