What Quantitative Easing 3 is all about

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Fed takes open-ended approach in its third attempt to stimulate the US economy

One expert said people in the economy have no clear sense of the goals of Fed chairman Ben Bernanke (above). But with the pronouncements on QE3, that has changed. PHOTO: REUTERS

Last Thursday; the Federal Reserve released a statement announcing a third round of "quantitative easing", or QE3; to stimulate the economy. Here 's a quick run-through of what that means.

Q: What is quantitative easing?

Short answer: It's an unconventional monetary tool used by central banks to stimulate the economy.

Answer that might make sense: Normally, when there's a recession, or the economy is limping along, the Federal Reserve or Fed will reduce short-term interest rates in order to spur more lending and spending. But right now, the Fed has cut interest rates as far as they can go and the economy is still struggling. This is known as the "zero bound". The Fed can't go any lower.

So, instead, the central bank can try quantitative easing. Since the Fed can just create dollars out of thin air, it can buy up assets like long-term Treasuries or mortgage-backed securities from commercial banks and other institutions.

This pumps money into the US economy and reduces long-term interest rates further. When long-term interest rates go down, investors have more incentive to spend their money now. In theory.

Q: Hasn't the Fed already tried quantitative easing?

Yes. Twice, in fact. In late November 2008, after the financial crisis hit, the Fed started buying up mortgage~backed securities and Treasury bills in order to boost the economy. By June 2010, the bank had bought about US$2.1 trillion worth of assets.

At this point, the Fed halted its actions, figuring that it had done enough.

But when the economy started weakening that summer, Fed chairman Ben Bernanke resumed the programme in August 2010, buying up another US$600 billion in assets in order to maintain the Fed's balance sheet. (Remember, the bank is holding a bunch of debt that slowly matures, so if the Fed does nothing, all that money it injected into the economy will eventually get sucked back out again.) This was known as QE2.

Q: Did QE1 and QE2 actually boost the US economy?

Academics have been churning out plenty of research on this question. The first round of quantitative easing appeared to be effective in preventing the economy from sinking into a giant depression. Economists say this was because everyone realised the Fed would do whatever it took to avoid deflation. It was essentially a giant confidence boost. The economy stopped sliding and inflation slowly rose. But the effects seemed to dwindle as the years went by. Experts are much more divided on how much QE2 has helped.

In theory, quantitative easing should work in two ways. First, it injects more cash into banks, allowing them to lend more. And second, it lowers interest rates - if the Fed buys up a bunch of mortgage-backed securities, for example, that should make it cheaper to borrow money to buy a house. In practice, interest rates do drop. But it's hard to figure out whether this translates into a boost to the actual economy. After all, low mortgage rates can only do so much if banks are scarred by the housing bubble and remain tightfisted about lending.

Q: How does quantitative easing help the economy?

In his testimony to Congress in June, Mr Bernanke explained why QE3 might bolster the economy. It would reduce the cost of borrowing money for corporations, bring down mortgage rates even further and potentially boost the stock market, increasing Wealth effects for consumers to spur more spending. (He did say, however, that he would much prefer to have additional help from Congress.)

Not everyone is convinced, though. Early this month, Professor Michael Woodford, a pre-eminent monetary theorist at Columbia University, released a long paper arguing that more quantitative easing is likely to be ineffective - because Mr Bernanke is acting too sporadically. The Fed will buy up US$600 billion worth of assets, hoping for a jolt, but people in the economy have no clear sense of what Mr Bernanke's goals are. Does he want a certain level of inflation? Will he start hiking interest rates if the economy starts growing? If so, when? That level of uncertainty can be paralysing.

Q: Is there a way to make QE3 work better?

The Fed is doing two things to try to improve QE3. First, the central bank will keep short-term interest rates low until mid-2015. Second, it will buy up US$85 billion (S$104 billion) worth of assets each month between now and the end of the year. But, unlike QE1 or QE2, this new round of purchases will be more open-ended. That's an important change. Here's the key bit from the Fed statement: "If the outlook for the labour market does not improve substantially, the committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved."

The purchases will continue until morale improves. What's more, the Fed noted that it will continue its policy of easy money "for a considerable time after the economic recovery strengthens".

In essence, Mr Bernanke is now taking Prof Woodford's advice - or at least part of it. (Note that the Fed did not set an explicit target for the economy, it left that vague.) The Fed is not just buying up a fixed quantity of assets and hoping that the economy lurches forward. It is saying that it will keep buying up assets and won't stop until things look better. Now we'll see if that actually shifts expectations and bolsters growth.

Washington Post

invest, The Sunday Times, September 16 2012, Pg 39