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What is Quantitative Easing?

November 08, 2010

The term quantitative easing has been tossed around a lot lately. Round two of Quantitative Easing is affectionately referred to as QE2. It is such a perfectly phrased combination of words that some may think that it is a good thing. It has some benefits. But it also some detriments. This article will define what Quantitative Easing is in simple terms along with what it means to you.


Quantitative Easing is a method of increasing the money supply by the central bank. This is typically done when interest rates can not be taken any lower as is the case right now in the United States. The short and simple way of thinking about this is that it is a way for the government to increase the number of dollar bills that exist in the economy.

What are the Pros and Cons?

If more dollar bills exist out in the economy, there will be more dollar bills out there competing for the same set of goods and services. So, if the money supply is increased by 10%, the floor under housing prices should rise. Without getting into whether housing prices are high, low or just right it is important to know that the value of homes should increase. This does not mean that prices will go up though if prices are at the high end of historical norms but it should reduce some of the downside pressure that may exist.

More dollar bills in the economy will mean that your pay rate should go up, making it easier to pay off your debts (student loans, car loans, credit cards, mortgagees, etc).

More dollar bills also means that GDP should increase for the simple reason that more dollar bills will be competing for the same goods and services.

This is all good news. But more dollar bills also means that inflation will occur. Probably at a higher rate than historical norms. This has the end effect of weakening the value of the US dollar in the world economy. So, goods from other countries will cost more for US consumers to buy. Of course, this also means that other countries will see US goods as being less expensive. Meaning a shift towards more US manufacturing could occur which would be nice in terms of helping out with unemployment.

What does this mean to you?

In short, Quantitative Easing means that inflation and dollar devaluation (relative to the world economy) will occur.

How does this work?

From wikipedia:

Ordinarily, the central bank uses its control of interest rates, or sometimes reserve requirements, to indirectly influence the supply of money. In some situations, such as very low inflation or deflation, setting a low interest rate is not enough to maintain the level of money supply desired by the central bank, and so quantitative easing is employed to further boost the amount of money in the financial system. This is often considered a "last resort" to increase the money supply. The first step is for the bank to "borrow" from the member bank reserve accounts, creating a depository liability. It can then use these funds to buy investments like government bonds from financial firms such as banks, insurance companies and pension funds, in a process known as "monetizing the debt". The net impact on the central bank balance sheet is zero.

For example, in introducing its QE program, the Bank of England bought gilts from financial institutions, along with a smaller amount of relatively high-quality debt issued by private companies. The banks, insurance companies and pension funds can then use the money they have received for lending or even to buy back more bonds from the bank. The central bank can also lend the new money to private banks or buy assets from banks in exchange for currency. These have the effect of depressing interest yields on government bonds and similar investments, making it cheaper for business to raise capital. Another side effect is that investors will switch to other investments, such as shares, boosting their price and thus creating the illusion of increasing wealth in the economy. QE can reduce interbank overnight interest rates, and thereby encourage banks to loan money to higher interest-paying and financially weaker bodies.

More specifically, the lending undertaken by commercial banks (excluding Swedish banks: the Riksbank does not require reserves from Swedish commercial banks) is subject to fractional-reserve banking: they are subject to a regulatory reserve requirement, which requires them to keep a percentage of deposits in "reserve",: these can only be used to settle transactions between them and the central bank. The remainder, called "excess reserves", can (but does not have to) be used as a basis for lending. When, under QE, a central bank buys from an institution, the institution's bank account is credited directly and their bank gains reserves. The increase in deposits from the quantitative easing process causes an excess in reserves and private banks can then, if they wish, create even more new money out of "thin air" by increasing debt (lending) through a process known as deposit multiplication and thus increase the country's money supply. The reserve requirement limits the amount of new money. For example a 10% reserve requirement means that for every $10,000 created by quantitative easing the total new money created is potentially $100,000. The US Federal Reserve's now out-of-print booklet Modern Money Mechanics explains the process.

A state must be in control of its own currency and monetary policy if it is to unilaterally employ quantitative easing. Countries in the eurozone (for example) cannot unilaterally use this policy tool, but must rely on the European Central Bank (ECB) to implement it. There may also be other policy considerations. For example, under Article 123 of the Treaty on the Functioning of the European Union and later the Maastricht Treaty, EU member states are not allowed to finance their public deficits (debts) by simply printing the money required to fill the hole, as happened, for example, in Weimar Germany and more recently in Zimbabwe. Banks using QE, such as the Bank of England, have argued that they are increasing the supply of money not to fund government debt but to prevent deflation, and will choose the financial products they buy accordingly, for example, by buying government bonds not straight from the government, but in secondary markets.

About the author:

Karl is currently a software engineer in Connecticut with a bachelors of science in electrical engineering from Clarkson University. He has been investing since 2001 and interested in value investing since 2005. Karl is continually striving to learn more about investment.

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