The Basics of Quantitative Easing

12/23/2008 12:01 am EST

Focus: FOREX

Kathy Lien

Managing Director and Co-Founder BKForex LLC, BK Asset Management

Quantitative easing (QE) are the latest buzz words in the financial markets. It is important to become intimately comfortable with these words because they will be the catch phrase of 2009 thanks to the latest interest rate cuts by the Federal Reserve and the Bank of Japan.

What Is Quantitative Easing?

Quantitative easing is a monetary policy tool that central banks use when they run out of room to cut interest rates. The word “quantitative” refers to the money supply, and easing money supply means to increase it. For many people, this term is new, and for good reason, because it was only coined by the Bank of Japan in 2001 after they took interest rates to zero. When that happened, they obviously had no more room to cut rates, which made quantitative easing their Plan B. Quantitative easing basically involves printing money to buy a variety of securities with the end goal of flooding the financial markets with cash, or liquidity. By doing so, it increases the amount of currency in circulation, which reduces the value of the currency and boosts inflation. A good way to look at this is if there were only 100 signed Babe Ruth baseball cards worth $1000 each in the world, and all of a sudden, another 1000 signed baseball cards were discovered, then you would expect each baseball card to now be worth a lot less. Having more baseball cards in the market at lower prices hopefully spurs more activity in the baseball card market. In many ways, the goal of quantitative easing is the same. By the flooding the market with liquidity, the central bank aims to promote lending and prevent a shortage in the future. Of course, quantitative easing is much more involved than baseball card trading.

What Outcome Can Be Expected from Quantitative Easing?

Given that quantitative easing has only ever been implemented once in Japan, there is not much precedent. However, with that in mind, we are sure that the Fed analyzed the outcome of Japan's zero interest rate policy before bringing US interest rates within a whisker of Japan's 2000 levels. The Bank of Japan embarked upon this new concept in monetary economics in its effort to fight a frustrating period of economic stagnation and decline in 2001, which lasted until 2006. With rates at 0%, the central bank was forced to implement some new level of policy to fight the wave of deflation that had plagued the country. Deflation, another renewed catch word in today's economic climate, is an overall decline in prices over an extended period of time. We are all familiar with how disastrous an inflationary state can be on an economy, and unfortunately, deflation is no different. The cause of the phenomenon is when consumers become so resistant to spending that sellers are forced to continuously cut prices. In Japan, the BoJ accomplished their easing targets by expanding the limits as to the types of securities that they would purchase. For instance, buying long-term treasuries, asset-backed securities, equities, and new levels of commercial paper. This is all in an effort to flood the financial system with so much excess reserves and liquidity that they would be forced to resume normal lending situations. In the first year of quantitative easing, USD/JPY rose 18.5%. This means that the Japanese yen weakened against the US dollar, which is a textbook reaction to quantitative easing. The Nikkei also dropped 28%. Between 2002 and the end of 2004, USD/JPY fell 22% as the Japanese economy began to stabilize. During that same time, the Nikkei recovered 20%, but not before it fell another 20%. Although it has been heavily debated whether quantitative easing drove the turnaround in the economy, most people agree that it put a halt to deflation.

Fed's Version of Quantitative Easing

With US interest rates pretty much at zero, the Federal Reserve has informally adopted its own version of quantitative easing. Some people may even argue that the Fed has been pursuing this strategy for months now. In conjunction with the Treasury department, the Fed has doubled their balance sheet in the past three months to more than $2 trillion. It has done this by purchasing direct equity investments in banks, easing standards on commercial paper purchases, made efforts to relieve institutions of their toxic asset-backed securities, and is now considering buying Treasury bonds and agency debt. By buying these assets, they are adding money into the financial system. Like the yen, quantitative easing exposes the US dollar to significant downside risks, but it is also the step that the central bank needs to take to stabilize the US economy and to prevent a deflationary spiral.