What It Is:
Quantitative easing is a strategy employed by a central bank like the Federal Reserve to add to the quantity of money in circulation. The premise (which is largely theoretical and untested) is that if money supply is increased faster than the growth rate of Gross Domestic Product (GDP), the economy will grow.
How It Works/Example:
To understand the rationale behind the strategy, it helps to look at the basic relationship among GDP, money supply and the velocity of money.
In general, GDP equals money in circulation (M) times the velocity of the money through the economy (V):
GDP = M * V
Velocity is the speed at which money passes through the hands of one person or company to another. When money is spent quickly, it encourages growth in GDP. When money is saved and not spent, the GDP of the country slows.
Through quantitative easing, the Federal Reserve tries to counteract falling velocity by increasing the money supply. It has two primary tools with which to do it.
The first is via the federal funds rate. Banks with excess reserves can lend money to other banks that need additional reserves before closing their books for the day. The federal funds rate is the interest rate the banks charge each other for these overnight transactions.
The Federal Reserve sets the federal funds rate. As one of the most important interest rates in the world, it is widely quoted in the press. Theoretically, a low federal funds rate should encourage banks to lend to individuals and businesses at higher rates — if they can borrow at 0% and lend to someone else at more than 0%, they make money.
The second tool the Fed uses is the open market operation (OMO). The Fed uses OMOs to buy or sell securities that banks generally own — mortgages, Treasury bonds, and corporate bonds. When the Federal Reserve buys securities, they trade the security for cash and increase the money supply. When they sell securities back to banks, they decrease the money supply.
Quantitative easing increases the supply of money available to the Federal Reserve to conduct OMOs. Since the Fed is the issuer of our money (technically they are Federal Reserve Notes), it can increase the actual number of dollars circulating in the global economy by simply issuing more dollars. Those dollars are then used to buy securities in OMOs, as described above.
Why It Matters:
In the past, the Federal Reserve has not resorted to this approach to manage the supply of money in the economy. But starting in 2008, it started buying large amounts of mortgage-backed securities (MBS) and Treasuries in order to add more money to the economy and help stabilize the banks.
Today, the Federal Reserve recognizes that banks are using very cheap short-term money to purchase longer-term securities and pocketing the difference in interest income. So the Federal Reserve has decided it wants to drive down longer term rates and remove the banks’ incentive to buy Treasuries.
If the Federal Reserve buys enough 2-year, 3-year, 5-year and 10-year Treasuries, they force an increase in their prices. And bond prices are inversely related to bond yields: when prices go up, yields go down. A lower yield means banks cannot make as much money using the overnight money at 0 – 0.25% and buying long-term Treasury bonds, since the yield on those bonds will be pushed lower and lower.
The hope is the banks will then be encouraged to lend more, thereby stimulating the economy.