The Ins and Outs of QE2

10/14/2010 12:21 pm EST

Focus: MARKETS

John Heinzl

Reporter and Columnist, GlobeInvestor.com

John Heinzl, reporter and columnist for GlobeInvestor.com, gives answers to frequently asked questions about quantitative easing.

“I’ve been reading a lot about quantitative easing, but I still can’t wrap my head around it. Can you break it down so a simpleton like me can understand it?”—M.H.

You’re right that quantitative easing (QE) has been in the news a lot. So far this month, The Globe and Mail has mentioned it 47 times—more references than Lindsay Lohan, Paris Hilton, Mahmoud Ahmadinejad, and Brett Favre combined (I counted). And we’ll be hearing more about it soon if the US Federal Reserve Board, which used quantitative easing to shore up the economy in the wake of the 2008 financial crisis, decides to launch a second round, known as QE2.

Despite extensive coverage in the mainstream press, many people are still fuzzy on what quantitative easing means. So today Investor Clinic presents an FAQ on QE.

What is quantitative easing?

When a central bank wants to stimulate the economy, the conventional method is to lower its official interest rate so consumers and businesses will borrow and spend. But when that doesn’t work—the US economy is still sucking wind despite a record low federal-funds rate of 0 to 0.25 percent—more extreme measures are required.

Under quantitative easing, the central bank expands the money supply by crediting its own account with freshly minted cash and pumping the funds directly into the economy. QE has been compared with “printing money,” although nowadays everything is done electronically.

What is the goal of QE?

With the money it creates ex nihilo—“out of nothing”—the central bank purchases financial assets including government bonds, corporate bonds and mortgage-backed securities from banks and other financial institutions. These transactions, called open market operations, are designed to have several positive consequences.

First, injecting more cash into the banks increases their excess reserves, which in turn gives them flexibility to lend more money to consumers and businesses and—hopefully—stimulate borrowing and growth.

Second, central bank purchases of bonds should drive up bond prices and push down yields (prices and yields move in the opposite direction). Because yields on government bonds are used as a benchmark for consumer and business loans, the cost of borrowing should also fall, again stimulating growth.

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Third, by lowering interest rates on fixed-income securities, other financial assets such as dividend-paying stocks become relatively more attractive, sending share prices higher and making investors wealthier (at least on paper). The wealthier investors feel, the more likely they’ll be to go shopping for a new car or house. Indeed, many observers believe the September stock market rally was triggered by expectations that the Fed will kick off another round of QE.

Does it work?

Certainly, QE is no magic bullet. Japan’s central bank used the strategy from 2001 to 2006, yet the country is still grappling with deflation and sluggish growth. This month, Japan announced a fresh round of QE to kick-start its flagging economy.

Similarly, the US economy is still struggling with high unemployment and weak growth even after the Fed’s first quantitative easing program, which ended in March.

However, economists say the outcome for both countries could have been far worse without any QE.

“The consensus view is that quantitative easing is very helpful,” said Sal Guatieri, senior economist with BMO Nesbitt Burns. “Without it, interest rates would be a lot higher than they are, the US housing market would be even more of a disaster, and I would venture to say the US would have gone into a depression without it.”

In Canada, the central bank hasn’t seen the need for QE, because the credit taps weren’t turned off to the same extent as in the US market, he said.

Still, some observers doubt that QE2 will have the desired effect. “For a start, investors have had a year-and-a-half to get used to the idea that unconventional monetary policy is no panacea for an economy saddled with debt,” said John Higgins, senior market economist with Capital Economics.

What are the risks?

Because the strategy involves increasing the money supply, critics worry that QE could ignite inflation. But Mr. Guatieri said there’s no immediate danger of that, for a couple of reasons.

First, “there is so much slack in the US economy in every market—labour markets, commercial real estate, residential real estate, product markets generally—that inflation pressures simply can’t take root,” he said.

Second, printing money for quantitative easing is not the same as printing money to finance a government deficit—something the US central bank isn’t doing.

“It’s not the same situation as in, say, Zimbabwe, where the government is just printing money so the government can pay its bills because the tax base is decimated and the private sector has simply fled the country and won’t lend any more money to the government,” he said.

What about the timing?

Many observers expect QE2 to begin after the Fed’s next policy meeting on November 3. Reinforcing that view, minutes of the Fed’s September 21 meeting, released Tuesday, showed officials were prepared to ease monetary policy “before long.”

QE is intended to be a temporary measure. Once the economy and employment begin a sustained recovery, the central bank would then reverse its easing measures, selling securities back to financial institutions while raising its benchmark interest rate. That would be late in 2011 at the earliest, Mr. Guatieri said.

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$500-billion: Minimum value of financial assets, in US dollars, the Fed is expected to purchase in the first six months of QE2, according to Merrill Lynch.

$1-trillion: Value of potential Fed purchases over the next year.

2%: Projected yield on 10-year US Treasuries by the end of 2010, down from 2.41 percent currently, according to Merrill Lynch.

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