All you need to know about Quantitative Easing and Tapering

In the recent times, Quantitative Easing policy of the US Federal Reserve has gained a lot of attention from businesses, investors and stock markets the world over. This has generated curiosity in the minds of many as to what it actually is and how it affects the world economy. This article is an attempt to satisfy such curious minds.

To understand quantitative easing, let us go through the story of recession in the US, its post effects, and how the economy got back on the path of recovery.

In the year 2008, the US realized the development of recession in its economy, evidenced by the bankruptcy of Lehman Brothers. As the housing bubble burst, borrowers failed to repay loans; banks and financial institutions went bankrupt; investments dropped; unemployment spread and consumption fell. Money supply in the economy reduced dramatically.

Some banks were bailed out to avoid the state of bankruptcy. After having faced huge credit crunch, these banks had become reluctant to lend to new or existing projects, thus furthering recession. The Federal Reserve (the central bank of the US) lowered the bank rates to promote lending at low rates of interest. The bank rate kept reducing and reached near zero, at a level after which it could not be reduced further. But this effort did not bear fruit as the banks and financial institutions were using the funds to invest in risk-free long-term government bonds. The deadlock of money supply worsened. Businesses needed funds, but the banks were not lending any.

At this stage, revival of US economy required the use of some unconventional monetary policy from the Federal Reserve. The Fed opted for Quantitative Easing (QE). This tool was first used by the Bank of Japan in 2001. Quantitative Easing, as the name suggests, eases pressure in the economy by pumping money into the system. How it was carried out is easy to understand. The Fed started purchasing long-term government bonds from the banks and financial institutions in large quantities. This increased the prices of such bonds, and lowered their yield. The bonds became an unattractive investment for banks and financial institutions. Liquidity with banks increased. Further, the Fed purchased non-performing assets of the banks and FIs, thus releasing pressure off banks’ Balance Sheets.

Now these banks had a huge amount of cash at their disposal. And they were no more willing to park the same in risk free government securities. You guessed it right! Banks and FIs lent to businesses, invested in shares and also lent to retail investors. The economy got on track again! Investments increased. Unemployed started getting employment. Consumer spending rose. Federal Reserve looked forward to meeting its inflation and unemployment level targets.

Quantitative Easing was implemented by the Fed in 3 successive rounds popularly called QE1 (2008), QE2 (2010) and QE3 (2011). QE1 got its name retrospectively on the introduction of second round of Quantitative Easing.

One question that may come to mind is that how did the Fed arrange the funds for the process. It did so by printing new currency. That does lead to the devaluation of currency, but the same boosts exports.

Despite all good that it did to the US economy, quantitative easing is not free of risks. It carries two major risks. First, the quantity and timing of action determines whether it will succeed or not. It is highly difficult to time the markets correctly. If not adequately implemented, it may cause uncontrollable level of inflation in future. Secondly, it carries the risk of failure of objective in case banks and financial institutions do not lend, rather accumulate cash waiting for other investment opportunities.

In the past few months, the US economy has showed signs of recovery. Unemployment has fallen. Hence, the Fed has considered tapering, i.e., reducing the support of Quantitative Easing to avoid excessive inflation. Initially, when in June 2013, the Fed announced that it was considering reducing the quantum of bond purchases by $20 billion per month, the markets crashed worldwide. Perhaps it was still not the right time for such huge withdrawal of support and hence, the idea was cancelled. But again in December 2013, the Fed decided to withdraw $10 billion per month. This was welcomed by the stock market as it rose immediately following the announcement.

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