Queen Elizabeth 2!! (Part 1)

As usual, in our Q&A style, let us explore this concept of QE

What's this QE thingy that many are talking about?

Well.. Wikipedia describes it as "The term quantitative easing (QE) describes a monetary policy used by central banks to increase the supply of money by increasing the excess reserves of the banking system. This policy is usually invoked when the normal methods to control the money supply have failed, i.e the bank interest rate, discount rate and/or interbank interest rate are either at, or close to, zero."

You think I understood that!!?

To put it simply, it's known as "printing money" though they don't generally print anything. A central bank(here, the Federal bank) first credits its own account with the money created ex nihilo (out of nothing), then proceeds to buy the treasuries(government bonds), mortgage backed securities from banks and other financial institutions in what is called open market operations. Then the banks get excess reserves and ..

Wait.. Hold it!!! You are saying that no money is printed.. So, where the hell are banks getting these excess reserves from??

Let us put it this way.. Suppose someone credits your bank account with a 1000 rupees, does that mean you will actually be receiving those 1000 rupees in cash? Does that mean the bank in which your account exists be receiving the 1000 rupees in cash right after the transaction is complete? The answer is no in both the cases. Similarly, here, the Central bank buys assets from private sector institutions – that could be insurance companies, pension funds, banks or non-financial firms – and credits the seller’s bank account. So the seller has more money in their bank account, while their bank holds a corresponding claim against the Central bank.

However, economists would still argue that QE is the same principle as printing money as it is a deliberate expansion of the central bank's balance sheet and the monetary base.

Just another doubt.. If the central bank is not going to print any money, how are the claims of those banks accounted for?

The money credited in bank accounts must later on come from taxpayers.

Ok! I get it now. Please continue..
So, then the banks get excess reserves required for them to create new money, and thus hopefully induce a stimulation of the economy, by the process of deposit multiplication from increased lending in the fractional reserve banking system.

Great. I understand the thing.. So, why is it so much popular now-a-days?

The US economy has entered into a considerable slump in recent days. However, this is not the only concern. The Fed is also worried about falling inflation, which it described as "trending lower". Consumer prices inflation has fallen below 1%, but other measures such as core inflation has fallen to lesser than 0.6%. In previous speeches, Mr Bernanke made clear that the Fed would not tolerate deflation - or falling prices. Deflation can become self-perpetuating - as has become the case in Japan in the last 20 years - because consumers may postpone spending decisions in the expectation of cheaper prices. Falling prices and wages would also make it more difficult for Americans to pay off their debts.

Another pressing concern for US is the unemployment rate which has currently risen above 10%.

Under such conditions, The Federal Reserve normally cuts short term interest rates to give you and me the incentive to borrow money. But what if that doesn’t work? Perhaps the banks aren’t willing to lend or despite low rates we aren’t interested in borrowing. So the Fed cuts rates again and again and again, but it doesn’t work. Now the rates are near 0% from the Fed and dirt cheap for you and me, but no one is borrowing and the economy is in recession. What to do? The Fed is running out of tools to stimulate the economy. So, as a last option, it has once again turned towards QE.

What do you mean by 'once again'? Is it not the first time Fed is using this policy? Also, when and where is it used in other countries?

Quoting from wiki

Quantitative easing was used unsuccessfully by the Bank of Japan (BOJ) to fight domestic deflation in the early 2000s. During the global financial crisis of 2008–the present, policies announced by the US Federal Reserve under Ben Bernanke to counter the effects of the crisis are a form of quantitative easing. Its balance sheet expanded dramatically by adding new assets and new liabilities without "sterilizing" these by corresponding subtractions. In the same period the United Kingdom used quantitative easing as an additional arm of its monetary policy in order to alleviate its financial crisis.

The European Central Bank has used 12-month long-term refinancing operations (a form of quantitative easing without referring to it as such) through a process of expanding the assets that banks can use as collateral that can be posted to the ECB in return for euros. This process has led to bonds being "structured for the ECB". By comparison the other central banks were very restrictive in terms of the collateral they accept: the US Federal Reserve used to accept primarily treasuries (in the first half of 2009 it bought almost any relatively safe dollar-denominated securities); the Bank of England applied a large haircut.

In Japan's case, the BOJ had been maintaining short-term interest rates at close to their minimum attainable zero values since 1999. With quantitative easing, it flooded commercial banks with excess liquidity to promote private lending, leaving them with large stocks of excess reserves, and therefore little risk of a liquidity shortage. The BOJ accomplished this by buying more government bonds than would be required to set the interest rate to zero. It also bought asset-backed securities and equities, and extended the terms of its commercial paper purchasing operation.

{We shall see how it's actually supposed to work, how it actually works, what are the main advantages with it and why the international community is apprehensive about it and various other things regarding QE in the next article on QE}

Celebrating everything,

Aravind M
http://www.aravind90.blogspot.com