Yesterday was another landmark day for the Federal Reserve - which decided to begin a new phase of "quantitative easing" aka QE3. The stock market sure loved the news as the Dow Jones Index surged over 200 points in the same day.
I got my hair cut that afternoon, and my barber asked me a couple of questions, that struck me as questions that many folks likely have. The first was, what is Quantitative Easing anyway? Kind of sounds like something more related to physics than finance. The 2nd question, came from talking about the 1st, which is, can the Federal Reserve just print money out of thin air or do they need to balance that with debt or something?
Maybe it's best to start by understanding the Fed's role….is that of a Central Bank. Prior the establishment of the Federal Reserve in 1913 there were numerous currencies in the U.S due to all of the immigration going on in those days. Banks sometimes honored some, made up their own exchange rates, and often ran out of them. Additionally, if banks ever ran out of money (lent to much out) there was nowhere for them to go and get more other than another bank. Banks would collapse, and account holders would get the shaft. People were afraid to keep their money in banks as a result, and the banking system was weak. So the Federal Reserve (Fed) was created to be the bank to the banks. Today, the Fed processes and clears about 1/3rd of ALL the checks processed in the country - almost 20 billion per year, and they charge a fee for this . Also, they are a backstop (the "Reserve") that makes sure banks can honor their customers withdrawals à they loan money to banks. The Fed makes money by charging fees for clearing checks, and loaning money to other banks à this is the Discount Rate
In normal times, when the Fed lowers the Fed Funds Rate (connected to Discount Rate) they make the cost to borrow money cheaper, and as a result create greater "liquidity" - or increase the money supply. This is because if money is cheaper to get (i.e. borrow) then it's also easier to part with (spend) and then money moves through our economy faster as a result. If this goes too fast, then inflation happens (more money chasing the same amount of goods/services), and then they will raise the Fed Funds Rate in order to slow things back down. This is most common monetary tool the Fed manages also known as "conventional monetary policy".
Quantitative Easing are "unconventional monetary policies". The Fed uses these when conventional ones become ineffective (interest rates at zero). As the root word implies "quantity", the idea is to inject a quantity of money into the economy. Hence, QE1, 2, and 3 have all involved the Fed buying a set amount (quantity) of bonds or Mortgage Backed Securities as the case of QE3. Again the goal is to add more money (liquidity) and to keep interest rates low - to entice people and business to spend it. Today, they want business to spend it by hiring people.
So, does the Fed print money? No. Technically, the Treasury does that through the U.S. Mint. Yet, when the Fed buys bonds and things, it does so not by using cash or getting a loan (they are the bank of last resort). Instead they issue themselves a credit, known as "increasing their balance sheet". It would be like you or I just sending our bank an instruction to credit our account by another X dollars! Nice huh? Since the beginning of the 2008 financial crisis the Fed has increased their balance sheet from < $1 Trillion, almost $3 Trillion today! Also, as Fed is also the bank for the US Treasury, and since the Treasury prints the money…..hmmmm! I'd have to say the Fed can print money - wouldn't you?
While this seems alarming, what no one thinks about is that the Fed can reverse of all of these measures someday too. They can sell bonds, and things off their balance sheet out of thin air too. Of course these measure have the counter effect and must be done when times are good……which we hope will be found at the bottom of this rabbit hole someday.
“Quantitative Easing,” Wikipedia, accessed Sept 14, 2012, http://en.wikipedia.org/wiki/Quantitative_easing
"How the Fed Works", howstuffworks, accessed Sept 14, 2012, http://money.howstuffworks.com/fed10.htm
"Federal Reserve Balance Sheet", Stimulus.org, accessed Sept 14, 2012, http://stimulus.org/financialresponse/federal-reserve-balance-sheet
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