The central bank monetary policy aims at increasing the money supply in the economy and it do so by buying government securities or other securities from the market. Quantitative Easing increases the money supply by lending financial institution with capital in an effort to promote liquidity in the economy.
It is considered as an unconventional monetary policy used by central banks to stimulate the national economy when the conventional monetary policy has become ineffective. Central bank uses the quantitative easing policy when interest rates have been almost close to 0% and have failed to produce desired effect. Recently, In order to support United Kingdom recovery the European Central Bank maintained interest rates at a record low of 0.5% and held its quantitative easing stock at 375 billion pound
Quantitative easing can be used to help ensure that the inflation doesn't fall below target but there is risk associated with this. The main side effect is the new money in the economy is expected to raise the consumer prices and give another incentive to buy more and this can act against the deflation- leading to higher inflation or it may not be effective if banks don't lend out their additional reserves.
INTRODUCTION
Central bank normally set the price of money using the official interest rates to regulate the economy. It achieve its interest rates targets mainly through open market operation, where central bank buys or sell short term government bonds from banks and other financial institution. When central bank disburses or collects money from these bonds, it affect the money circulation in the economy while simultaneously affecting the price and thereby the yield on short term government bonds. And this in turn the interbank interest rates.
Higher interest rates make borrowing less attractive because taking out loan becomes more expensive. But interest rates cannot be cut below zero(0%) and when official rates get close to zero the central bank cannot lower it further, such a situation is termed as liquidity trap. In such a situation central bank perform Quantitative Easing by purchasing pre determined amount of bonds or other assets from financial institution without reference to the interest rate.
The main aim of such policy is to increase the money supply rather to decrease the interest rate further. This is often the last resort to stimulate the economy.
HOW QUANTITATIVE EASING WORKS.
STEP3
INVESTORS TURN TO OTHER ASSETS LIKE STOCKS, CORPORATE BONDS AND EVEN COMMODITIES PUSHING THEIR PRICES HIGHER
STEP2
THIS REMOVES THESE SAFER INVESTMENTS FROM THE MARKETS AND PUSHES DOWN YIELDS ON THESE INVESTEMENTS.
STEP 1
THE FED BUYS THE MORTAGAGE SECURITIES AND TREASURY FROM THE BANKS AND SECURITIES DEALERS THROUGH THE TRADING ARM OF NEWYORK FED.
THE RISK
CRITICS ARGUE THAT THE FED MONEY PRINTING COULD CAUSE A DOLLAR COLLAPSE AND SPUR IN THE INFLATION LATER, AND DOUBT IT WILL FEED THROUGH TO THE BROADER ECONOMY
THE GOAL
LOWER RATES ON BONDS WILL KEEP THE BONDS AND OTHER CONSUMER RATES LOW AND ENCOURAGE INVESTORS TO BUY ASSETS WITH HIGHER RETURNS AND MORE RISKS, SUCH AS STOCKS AND CORPORATE BONDS
AMOUNTS
The US Federal Reserve held between $700 billion and $800 billion of Treasury notes on its balance sheet before the recession. In late November 2008, the Fed started buying $600 billion in Mortgage-backed securities (MBS). By March 2009, it held $1.75 trillion of bank debt, MBS, and Treasury notes, and reached a peak of $2.1 trillion in June 2010. Further purchases were halted as the economy had started to improve, but resumed in August 2010 when the Fed decided the economy was not growing robustly. After the halt in June holdings started falling naturally as debt matured and were projected to fall to $1.7 trillion by 2012. The Fed's revised goal became to keep holdings at the $2.054 trillion level. To maintain that level, the Fed bought $30 billion in 2-10-year Treasury notes a month. In November 2010, the Fed announced a second round of quantitative easing, or QE2, buying $600 billion of Treasury securities by the end of the second quarter of 2011. A third round of quantitative easing, or QE3, was announced by the Federal Reserve in September 2012. The third round includes a plan to purchase US$40 billion of mortgage-backed securities (MBS) per month. Additionally, the Federal Open Market Committee (FOMC) announced that it would likely maintain the federal funds rate near zero
EFFECTIVENESS
According to the IMF, the quantitative easing policies undertaken by the central banks of the major developed countries since the beginning of the late-2000s financial crisis have contributed to the reduction in systemic risks following the bankruptcy of Lehman Brothers. The IMF states that the policies also contributed to the improvements in market confidence and the bottoming out of the recession in the G-7 economies in the second half of 2009.
According to Martin Feldstein, QE2 led to a rise in the stock-market in the second half of 2010, which in turn contributed to increasing consumption and the strong performance of the US economy in late-2010..
RISKS
In November 2010, a group of conservative Republican economists and political activists released an open letter to Federal Reserve Chairman Ben Bernanke questioning the efficacy of the Fed's QE program. The Fed responded that their actions reflected the economic environment of high unemployment and low inflation. Lowering interest rates hurt the economy as the people who depend on interest income spend less in response to their reduced income.
Quantitative easing may cause higher inflation than desired if the amount of easing required is overestimated, and too much money is created by the purchase of liquid assets. On the other hand, it can fail if banks remain reluctant to lend money to small business and households in order to spur demand. Quantitative easing can effectively ease the process of deleveraging as it lowers yields.
The member of the Federal Open Market Committee to vote against QE3, Richmond Federal Reserve Bank President Jeffrey M. Lacker said, the impetus is to aid the housing market. That's an area that's fallen short in this recovery. In most of the US post war recoveries, we can see the more priority has been given on backing of housing sector ,the reason it doesn't happen this time is because the recession is caused by building too many houses before the recession.
CONCLUSION
So, does quantitative easing work or not is a difficult question to answer. Historically, it has worked moderately for Japan during 2001 to 2006. It also helped reduce the impact of recession during 2007 to 2010 in the United States and the United Kingdom. On the contrary, it has been disastrous for Zimbabwe in 2002 when quantitative easing led to hyperinflation.
The problem with quantitative easing is that it depends entirely on the banks, i.e., if the banks lend the additional money available with them it works, but if the banks do not lend out the money it will be ineffective.
Now the catch is that even the banks can do little to solve this problem. Loan disbursal is an independent activity. The bank's loan desk generally doesn't refer to its reserve before sanctioning a loan. The bank evaluates the loan worthiness of a borrower and if the borrower satisfies the conditions, he gets a loan. If the borrower is not creditworthy, he will not get a loan anyway, even if the bank has money to lend. And if the bank relaxes its norms to sanction loans, it can result in bad loans, which is even more undesirable.
So, all we can say is quantitative easing alone cannot do any magic if the fundamentals are not strong. On the other hand, if the investors have confidence in the growth potential of a country then monetary policies like quantitative easing can give that much-needed confidence to the investors and borrowers to dream big and aim high.
