The Federal Reserve typically slashes interest rates in recessions to revive an ailing economy — but in more severe crises, it might not be enough.
Desperate times call for desperate measures, and in the Fed’s eyes, that means breaking out the more “unconventional” tools of keeping borrowing costs cheap and boosting growth. One such policy has become a household name among investors and Fed watchers in the days since the Great Recession of 2007-2009 — it’s called “quantitative easing.”
Here’s everything you need to know about this recession-fighting Fed policy.
Quantitative easing definition
Quantitative easing (also known as Q.E.) is a nontraditional Fed policy more formally known as “large-scale asset purchases,” or LSAPs, where the U.S. central bank buys hundreds of billions of dollars in assets — mostly U.S. Treasury and mortgage-backed securities — to push down longer-term interest rates and provide additional stimulus to the economy.
The program is considered “nontraditional” and “unconventional” because it’s different from what the Fed usually does: adjusting the benchmark federal funds rate. That’s how the Fed normally guides the U.S. economy, lowering its key borrowing rate to stimulate growth and raising rates to stabilize it. The rate, however, normally only directly influences shorter-term rates, such as deposit yields and credit card rates.
But when the Fed took interest rates all the way down to near-zero as the U.S. financial system tumbled into the Great Recession, the economy needed more juice, given the severity of the crisis. That’s when it introduced the first round of Q.E. in March 2009, modeling it after similar policy steps that the Bank of Japan took in the early 2000s.
How quantitative easing works
Quantitative easing works through open-market trading operations at the regional Federal Reserve Bank of New York. The Fed buys assets through the primary dealers with which it’s authorized to make transactions — financial firms that buy government securities directly from the government with the intent of selling it to others. The Fed then credits banks’ accounts with the cash equivalent in value to the asset it purchased, which increases the size of the Fed’s balance sheet.
“By virtue of taking the bond off the market, it replaces it with cash in the system, meaning there’s now more cash available for lending to consumers, businesses and municipalities,” says Greg McBride, CFA, Bankrate chief financial analyst.
The Fed mainly buys 2-year and 10-year Treasurys, though it isn’t limited just to bonds of those durations. By buying these assets, the Fed increases demand for those securities, raising prices but pushing down yields. The Fed can also purchase federal agency debt and mortgage-backed securities. That, in turn, increases the availability of credit in private markets and can help revive mortgage lending.
Semi-annual coupon payments are remitted back to the U.S. Treasury. When those securities ultimately mature, they roll off the balance sheet, with the money all going back to the Treasury.
The purpose of quantitative easing
But how it works isn’t as important as what it achieves. Q.E. helps add more life to the financial system in times of severe distress by pushing down interest rates on the longer-dated borrowing not directly controlled by the Fed’s interest rate lever, including the cost of taking out a mortgage or auto loan.
“This usually gets done when we’re coming out of some horrendous crisis,” says Dec Mullarkey, managing director of investment strategy at SLC Management, the asset management arm of Sun Life Financial. “Ultimately the intent is, you are going to increase lending, opportunity, and borrowing, and that will create growth in the economy.”
It also can influence broader market interest rates by directly lowering the yields on Treasury securities, which are tied to many other types of borrowing and instruments in the market. It can ultimately drive down corporate and municipal bonds, along with consumer and small business loan rates.
Q.E. also increases the money supply, boosts lending and can help revive choked markets by purchasing issued debt that’s been piling up on the market for a while. That makes it easier for banks to free up capital, writing out more loans and buying other assets.
“It’s like dropping a rock in a pond and seeing the waves ripple out in every direction,” McBride says.
Example of quantitative easing
Despite being a relatively unconventional tool, many central banks have tried their hand at some form of quantitative easing, with the policy implemented across Europe and Asia.
The Bank of Japan was the first central bank in the modern era to attempt to revive a sputtering economy through a policy it called “quantitative easing.” After facing a financial crisis in the 1990s, the Bank of Japan in March 2001 started growing the amount of bank reserves in the system.
Account balances increased to about ¥35 trillion — what’s roughly $324 billion — mainly through monthly purchases of Japanese government bonds (JGBs). Eventually, however, the Bank of Japan would transition its purchases away from government debt and into that of privately issued debt, buying corporate bonds, exchange-traded funds and real-estate investment funds. The program officially concluded in March 2006.
The Bank of England introduced a similar Q.E. program during the global financial crisis of 2008, purchasing in total about £200 billion worth of government debt, mainly gilts. England’s central bank has since made three more forays into Q.E., in response to the European debt crisis, Brexit and the coronavirus pandemic.
Quantitative easing in the U.S.
The Fed has only officially adopted “Q.E.” — it would rather refer to the process as LSAPs — during the financial crisis. The Fed announced the first round of Q.E., known as “QE1,” in November 2008. It officially kicked off in March 2009 and concluded a year later, with the U.S. central bank purchasing in total $1.25 trillion in mortgage-backed securities, $200 billion in agency debt and $300 billion in long-term Treasury securities.
A second round, dubbed “QE2,” was then announced in November 2010, followed by another iteration known as Operation Twist, and then “QE3.” In August 2007, before the financial crisis hit, the Fed’s balance sheet totaled about $870 billion. By January 2015, after those large-scale asset purchases had occurred, its balance sheet swelled to $4.5 trillion.
The Fed can only purchase government-backed debt under its current mandate, though it can get around those guidelines in emergency situations by creating a special vehicle with funds from the Treasury as a backstop.
The Fed started growing its balance sheet again in the fall of 2019 after dysfunction in the market for repurchase agreements sent interest rates soaring. As a result, the Fed started injecting cash in the form of short-term loans in exchange for Treasury bills as collateral while also conducting overnight lending operations. On Oct. 4, 2019, the Fed said it would start “organically” growing the balance sheet again, at an initial pace of $60 billion each month — mainly by purchasing Treasury bills.
Meanwhile, the coronavirus pandemic prompted the Fed to get back in the game even more. The Fed has pledged to buy Treasury securities, agency mortgage-backed securities and now commercial mortgage-backed securities at “at least” the current pace of about $80 billion each month for Treasury security purchases and about $40 billion for mortgage-backed securities.
Since the coronavirus crisis, the balance sheet has ballooned to above $7 trillion, with most experts predicting it will peak at around $9.75 trillion, according to Bankrate’s June Fed Forecast survey.
But calling these programs Q.E. wouldn’t exactly be accurate. Fed Chairman Jerome Powell and co. have noted that these operations are all about restoring proper market functioning, rather than reducing long-term interest rates, though that has been an unintended effect of both policies. The Fed’s repo operations are also about purchasing shorter-dated assets, which don’t provide as much stimulus to growth by lowering rates.
“A lot of those other steps that we’ve seen the Fed take are temporary, and they’re designed to assure proper functioning of financial markets,” McBride says. “It’s the equivalent of making sure that the plumbing is working, and once it is, the plumber leaves.”
How quantitative easing can impact you
Some experts have questioned whether Q.E. could lead to runaway inflation by dramatically increasing the money supply. That never came to fruition following the Great Recession, with price pressures remaining subdued and below the Fed’s desired 2 percent target for most of the previous decade-plus-long expansion.
That’s not to say it couldn’t originate after the coronavirus pandemic, given that both Congress and the Federal Reserve have gone farther and faster than ever to juice up the economy and provide it with a boost. But price pressures could also originate from disrupted supply chains and shortages, an avenue that wouldn’t be directly because of Q.E. interventions.
But one aspect of inflation has appeared to be a given when it comes to Q.E.: stock valuations. Because the program pushes down bond yields, some experts have argued that it facilitates more risk-taking among investors, pushing them into higher-returning investments, like stocks and real estate. But even though some experts have warned of asset bubbles, it might also be generating growth in economic activity, according to McBride.
Other experts have argued that Q.E. might not boost borrowing and lending as much as intended, given it’s a policy introduced in deep recessions when banks are pickier and consumers are more frugal.
“All the academic studies show it helped a little, but no one’s saying this is a home run,” Mullarkey says. “Banks in particular did their due diligence and were fairly strict on lending guidelines. It didn’t flow into consumers the way you might’ve expected, and consumers in general pulled back on borrowing.”
And even though the Fed and other central banks are a long way from slowing down their “Q.E.”-lite programs, the past might suggest it won’t be an easy process. When the Fed shrunk its balance sheet by about $1 trillion in the years after the Great Recession, investors grew apprehensive. Stocks in December 2018 had their worst month since the Great Depression when Powell described the process as on “autopilot.”
If you’ve been lucky enough to refinance your mortgage to a lower rate in 2020, you can send your thank you letter to the Fed. Mortgage rates held at historic lows of about 4 percent in 2019, and in some cases, have fallen to below 3 percent this year, largely thanks to the Fed’s efforts.
That represents the most direct way you can feel the impact from Q.E. — and if it’s not in your wallet, it’s in your 401(k).
“It is a way for the Fed to reduce borrowing costs for a much broader segment of the borrowing public,” McBride says. “This gives the Fed more of a direct impact on things like mortgage rates and car loan rates, than their traditional tool — the fed funds rate — which tends to have the most pronounced impact on deposit rates, credit card rates and home equity lines of credit.”
Featured image by Daniel Slim of Getty Images.