Until a few days ago, few people had even heard of quantitative easing (QE). But today, in the wake of the Federal Open Market Committee (FOMC) meeting, it's all anyone's talking about. Here are four things you need to know about QE.
1. What is it?
In broad terms, QE is an open market operation that the Fed uses to achieve its policy goals. Generally, when there's a shortage of money in the economy, the government's initial solution is to cut interest rates, which encourages people to spend, not save. If all goes well, spending increases and interest rates can return to normal. But that doesn't always happen, and when the government has lowered interest rates to a point where it can't lower them more, it turns to QE.
Australian comedic duo Clarke and Dawe attempted to explain the phenomenon of creating money out of thin air in this YouTube video:
2. How does it work?
First, a central bank purchases assets — typically, government bonds — from private companies and institutions such as insurance companies, pension funds, and large retail banks. The increased demand for these government bonds pushes up their value, making them more expensive to buy. Government bonds thus become less attractive as an investment, leading the companies that initially invested in the bonds to find new ways to invest their money, such as funding new businesses or lending to individuals.
The hope is that this newfound enthusiasm for lending to individuals and businesses will lower the interest rates charged, leading to greater spending, and enabling the economy to turn over a new leaf.
If you're more of a visual learner, you can watch the BBC explain QE with diagrams and the whole shebang:
3. How has QE affected our economy?
The first 18 to 24 months of QE implementation were generally a success, but since then, the results have been less encouraging. Under QE, commodity prices have remained stable, so QE has had diminishing returns. The prime example of this is oil prices (which are heavily correlated with gas prices), where an increase in the price of a commodity (gasoline) is essentially equivalent to a tax increase.
Here's a rather serious but informative talk by Financial Times columnist John Kay on the effects of QE:
4. What's the Fed's QE exit strategy?
While it's difficult to say how much longer we'll be dealing with QE in the United States, the current unemployment rate is not far from the Fed's 6.5% guideline, so we may be moving away from QE in the next 12 months. The FOMC is scheduled to release a statement today that summarizes its two-day meeting, so hopefully we will have a better idea of the Fed's exit strategy shortly.