Quantitative Easing: Demystified


Quantitative easing explained
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What is Quantitative easing?

Quantitative easing is an unconventional monetary policy tool which was used by the Central bank of the USA (Federal reserve) to boost the economy after the financial crisis of 2007-08. (Read more about monetary policy in this article: Monetary policy)

The federal reserve had to resort to quantitative easing because the conventional monetary policy tools used to control money supply had become ineffective.

The main tool of conventional monetary policy in the USA is the federal funds rate. The Federal funds rate is the rate at which banks lend overnight to each other. It is the interbank rate. (In India, the key policy rate is repo rate. Though, its mechanism is not the same as the Federal funds rate. Repo rate is the rate at which RBI lends to the banks against securities. Read it in details in this article)

In the aftermath of the financial crisis, the United States started reducing its federal funds rate to increase the money supply in the economy. It was intended to boost the economy and lower the unemployment rate. By December 2008, interest rates had reached to 0%. It became impossible to cut interest rates further and hence quantitative easing was used.

In quantitative easing, Federal reserve bank buys Government bonds and other financial assets from commercial banks to inject cash into the economy.

Japan was the first country to use Quantitative easing.

From where does the Fed get money to buy bonds?

The money is created electronically and credited in the reserves accounts of the banks.

When Fed buys bonds from the bank, it increases its reserves. Banks have to keep a certain percentage of deposits as reserves with the Fed. Increasing the reserves lets banks lend more money as now  it has extra reserves parked with the Fed.

How does Quantitative easing work?

Quantitative easing is the buying of Government bonds from the banks. It has the following effects:

  • The price of the bonds increases as its demand increases.
  • Their interest rates reduce.
  • Bank has more money kept as reserves than it is required. It can lend this money to consumers and businesses. Hence, money supply in the economy increases.

What is QE1, QE2 and QE3?

The quantitative easing was done in three phases or rounds. QE1, QE2 and QE3 refers to the first, second and the third round of quantitative easing respectively.

In the first phase of quantitative easing called QE1 (Nov 2008 to August 2010), Fed bought $1.7 trillion worth of financial assets.

Under QE3 ( Nov 2010 to June 2011), Fed purchased a total of $ 600 billion of assets from the bank.

Under QE3 (September 2012- October 2014), Fed was buying $85 billion worth of financial assets a month from the banks.

What is tapering?

Tapering is nothing but the gradual reduction in this bond/ asset-buying programme of the Fed.  QE3 did not have a definite end date. Fed had announced that quantitative easing (or bond-buying) will continue till the economy shows signs of recovery and unemployment rate reduces substantially.

In June 2013, Fed announced that it could reduce its bond-buying programme gradually if the economic data is positive. But, the announcement had a negative impact on stock markets. It fell by approximately 4.3% over the next three trading days. The stock markets of emerging countries like India were also affected. The decision sent ripples throughout the global economy.

In September 2013, the Fed decided to postpone the tapering of its bond-buying program till it was expected to get positive sentiments from the markets.

Finally, the Fed gradually put an end to Q3 within a span of 9 months from Feb 2014 to Oct 2014.

What was its impact on India?

Most of the capital inflows in India after 2008 were a result of quantitative easing. QE put lots of money in the hands of investors and they preferred to invest it in emerging nations like India because these countries remained resilient even in the face of the economic crisis.

But, when Fed had announced tapering for the first time in June 2013, it led to a flight of this capital from India. This was because tapering implied that US economy is slowly recovering and investors decided to shift their capital from risky emerging market economies like India to the United States.

Between June and August, Foreign Institutional Investors (FIIs) pulled out 230 billion rupees from the stock markets. This selling pressure led to a decline in Sensex by 2000 points. The value of the rupee was also hit. The Rupee lost 27% in 3 months.

The Rupee declined to new lows because as investors shifted their money from India to the USA, the demand for rupee decreased with respect to the dollar.

Though other emerging countries were also hit, India became particularly vulnerable. This is because India had very large current account deficit (CAD). It was dependent on FIIs for capital and hence its reversal gave a huge shock to the economy.

In September 2013, the Fed decided to postpone the tapering till it was expected to get positive sentiments from the markets.

But, when fed began to actually scale back the QE program in Feb 2014, it didn’t have much impact as India’s macroeconomic fundamentals had improved substantially. India wasIndia’s current account deficit had narrowed down. Growth had returned to normal and inflation was also under control.

Another reason for less impact was that markets had realised that tapering is inevitable and had already factored the risk of tapering in their valuation.

To conclude, while quantitative easing was a tool for monetary easing, tapering cannot be considered as monetary tightening. It is just that Fed’s monthly program to buy bonds (QE) have been stopped. As and when fed decides to sell back the bonds it accumulated, it might create panic again in the markets.

Fed has also decided that once the economic recovery is underway, it will start increasing its interest rates from 0 %.

The Federal Open Market Committee had met recently on September 2015 to decide if it is a right time to start raising interest rates. Even though growth in the country had returned to normal, the USA decided against increasing rates because of the slowdown in China as well as the global commodities market. Increasing the rates would have created panic again in the market.

Read this article to learn about the China’s stock market crash in September 2015.

The topic for this post was suggested by a reader on the ‘contact us’.

Have any Question or Comment?

2 comments on “Quantitative Easing: Demystified

Ritika Garg

Thanks for making us understand this complex topic in such a easy manner..!!

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Ritika Garg

I did not understand the concept of reserves in this. Could you please explain this further ? Plus from where Fed is financing its purchases of these govt bonds ?

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