Since the latest recession, the Federal Reserve has instilled periods of quantitative easing, also known as QE. This term is what the policy of buying bonds and assets to increase economic growth has been called by the Fed. By the end of 2013, a tapering process for the bond-buying was supposed to begin but has recently been put on hold by the Reserve.
But what exactly is quantitative easing, how does it work, and how does it affect the economy?
What is Quantitative Easing?
Quantitative easing is the name of the Federal Reserve’s program for buying bonds from its member banks. The purpose of quantitative easing is simply to reduce interest rates and increase growth of the economy.
QE3, the most recent policy, has the Reserve buying 85 billion dollars of bonds every month to push money into the economy. Recently, the Fed has announced that it will eventually phase out the amount of purchases if the economy improves. Yet the tapering will begin later than expected.
How Does Quantitative Easing Work?
The Federal Reserve credits the banks’ reserve accounts in exchange for MBS and Treasuries. The reserve account is the amount that each bank must have when they close nightly.
According to the Reserve Requirement, the banks must have 10% of deposits at the local Federal Reserve Bank or in cash.
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When the Federal Reserve adds credit, the banks have an extra amount on reserve, which can lead to banks lending to other banks. When the banks try to release their reserves to other banks, the interest rate drops (this is the Fed funds rate, the root for all interest rates).
Why do they do it?
Quantitative easing increases the supply of money because lower interest rates allow the banks to increase their amount of loans, which allows business to expand and consumers to take out credit.
This keeps the dollar’s value low, making stocks seem more attractive to foreign investors, as well as American goods for exporting.
Does it work?
After the creation of the bond-buying program, rates fell slightly. For the average rate of a 30 year mortgage, the rate went from 3.55% at the creation of QE3 to 3.35% in May, according to Freddie Mac. There has also been a 17% increase since the launch of QE3 for sales of existing homes.
The San Francisco Federal Reserve Bank published a report in the summer that stated QE2, a quantitative easing program dealing with asset-buying, added less than one percent to the rate of economic growth overall, but 2.8% initially. This overall did not help much to spur growth and create jobs. The report said that any growth was mostly due to the low interest rates, allowing people to make long term investments.
As stated in The Economist, Unemployment has gone from 8.1% to 7.3%. The goal was to stop QE when it hit below 7%, yet job growth has slowed down again, with the labor-market participation at the lowest it has been in over 30 years. Debt rates across the nation have fluctuated as well, with people relying on services such as National Debt Relief to assist them in financially difficult times.
Will interest rates rise, if bond purchases end?
It’s already happening. Since the idea of ending the stimulus caused an increase by 1.2 points since its arrival in May; new home sales have decreased steadily since July, as did contracts to buy older homes.
How will it affect the economy’s recovery?
On September 18, the Federal Reserve released a statement about QE and the decision to not instill tapering quite yet: “To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens.”
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The Chairman of the Federal Reserve, Ben Bernanke, said that the Fed will decrease its bond buying if they think the economy is gradually improving but if growth stalls again, the bond buying will continue. Bernanke also said that if the economy grows faster than expected, the bond-buying will end sooner than its expected mid-2014 date.
Dave Landry Jr. is a small-business adviser and investor who enjoys blogging and interacting with financial consultants and entrepreneurs on the web. He hopes you enjoy this article.