What is Quantitative Easing? – A Brief Explanation

Since we’ve found ourselves in economic turmoil starting from the so-called Great Recession, an obscure monetary tool like quantitative has entered mainstream awareness. Yet the unique features of our current economic conditions have caused this practice to become central to the economic recovery plans of the United States and other nations as well.

If you have been following the news lately, then you’ve probably heard of the term quantitative easing. Quantitative easing is a means to stimulate the economy when more traditional stimulus methods have either failed or become impractical. One of the most powerful tools central banks have is their ability to lower interest rates, thereby making borrowing for business growth and investment more appealing. However with rates already in the zero range, there is presently simply no way to lower them any more.

Therefore the central banks are using their ability to essentially create money out of thin air by buying assets such as mortgage backed securities. By increasing the money supply this keeps interest rates low and theoretically gives investors more incentive to spend money before the rates go up again.

Quantitative Easing in the United States
The United States has already had two previous rounds of quantitative easing with less than impressive results. The first and largest round was in the immediate aftermath of the 2007 fiscal crisis. When this proved mostly ineffective, another round was announced in 2010. Last fall yet a third round began, this time with changes designed to hopefully improve its effectiveness.

Expanding the money supply always runs the risk of sparking inflation once the economy improves, thereby choking off the very recovery tactic quantitative easing was meant to create. This ever present threat can create uncertainty in making long term investments. The low interest rates also discourage savings and punish those such as the elderly who are dependent upon interest on their investments for their livelihood. Some observers claim it is artificially creating a stock market boom because with interest based investments yielding so little, the only place to make a decent return is in the far riskier stock market. This can create financial bubbles and irrational investing strategies exactly like what caused the Great Recession in the first place.

The balancing act the Fed is performing is to end quantitative easing at exactly the right time, before any bubbles burst and without sparking runaway inflation. It will be interesting to see if it can be done.