The Federal Reserve seeks to maintain stability in the United States economy through monetary policy. While monetary policy is often synonymous with interest rates, the Fed has multiple tools to impact the economy. One of these tools is quantitative easing, or the large-scale purchases of assets in open markets.
The Fed has implemented quantitative easing programs four times since the financial crisis of 2007-2008. The most recent quantitative easing program was undertaken in 2020 in response to the COVID-19 pandemic and subsequent recession. This article will explore the past quantitative easing programs and their effects on the U.S. economy.
What is QE and How Does It work?
Quantitative easing, sometimes shortened to QE, is a type of non-traditional monetary policy that is implemented by the central bank of a nation. This type of policy includes large scale purchases of assets in order to stimulate or stabilize the economy. QE is typically implemented after other monetary policy tools have been used—usually when interest rates are already at their lower bound and economic output is still below the central bank’s target.
In order to buy assets on the market, the Fed creates new bank reserves. This process is commonly referred to as printing money although it is accomplished digitally. With the newly created funds, the Fed buys securities from major financial institutions. In the past, the Fed has purchased Treasury securities and mortgage-backed securities. These purchases effectively swap the bank’s investment holdings for cash while increasing the overall money supply. With more cash, banks are more inclined to make loans.
When quantitative easing is implemented, interest rates tend to decline. When the Fed enters the market as a major buyer, supply and demand principles push interest rates lower. This encourages individuals and businesses to take on loans at the new, lower rates.
Additionally, when interest rates are low, investors turn to riskier investments, like equities, to bolster their returns. Because of the additional capital entering equity markets and the incentives for businesses to borrow funds for expansion, quantitative easing can lead to larger stock market gains.
Finally, there is a psychological effect of quantitative easing. When the Fed is engaged in buying securities, the perception is that the Fed is taking an active role in bolstering the economy. This perception can lead to more confidence in the stability of the underlying securities and stimulated economic performance.
While quantitative easing has many benefits, there are also downsides. Because quantitative easing increases the money supply, it can lead to or exacerbate inflation. There is also research showing that large scale asset purchasing can lead to asset bubbles and income inequality, though these findings are somewhat contentious.
History of Quantitative Easing in the US
The U.S. has implemented quantitative easing four times. The first was in November 2008 in response to the global financial crisis. The previous quantitative easing programs have similarities, but the type of securities and duration of the programs have varied.
The global financial crisis and Great Recession led to widespread unemployment and reduced business output. By December 2008, the Fed had lowered the Fed funds rate from 5.25% in September 2007 to near zero. With interest rates near their lower bound and the economy continuing to contract, the Fed announced a plan to purchase large quantities of securities in an effort to put further downward pressure on yields.
In March 2009, the Fed expanded its asset purchase plan in an effort to bolster the still floundering economy. Between March 2009 and March 2010, the Fed purchased $200 billion in agency debt (debt from Fannie Mae, Freddie Mac, and Ginnie Mae), $1.25 trillion in mortgage-backed securities and $300 billion in long-term Treasury debt.
Government purchases during this time frame constituted about 22% of the market for these assets. In August 2009, the FOMC announced that it would gradually reduce the pace of Treasury purchases with the conclusion being October 2009. Then in September 2009, the FOMC announced the intention to gradually slow other asset purchases with a conclusion in Q1 2010.
After the conclusion of QE1, business output and employment remained below Fed targets. The Fed funds rate was still at its lower bound, so the Fed announced a second round of quantitative easing. This time, the Fed only purchased long-term Treasury securities. On November 03, 2010 Fed leadership announced a plan to purchase $600 billion of long-term Treasuries at $75 billion per month through Q2 2011. These purchases concluded in June 2011.
In the third quarter of 2012, economic activity was expanding but doing so slowly. Unemployment remained elevated and business investment was slower than the Fed would like. With the Fed funds rate at the lower bound, the Fed once again turned to the unconventional policy of quantitative easing to spur the economy. On September 13, 2012, monthly purchases of $40 billion in mortgage-backed securities were announced and a plan to increase long-maturity Treasury securities holdings at $45 billion per month was also implemented.
This round of quantitative easing was different than the previous two iterations because the Fed did not specify a total purchase amount or a timeline for the purchases to conclude. This left purchases open-ended and dependent on market conditions. Then in December 2013, the Fed announced tapering of purchases under QE3. The purchases concluded in October 2014.
Rates were already low heading into the pandemic as the Fed funds rate was between 1.5 and 1.75% leading into March 2020. The Fed cut interest rates twice in that month, bringing them to the effective lower bound. Because rates were already so low, the stimulus to the economy from reducing rates to the lower bound was limited.
At the March 15 meeting, the Fed also began QE4 which included monthly purchases of $80 billion of agency debt and $40 billion of mortgage-backed securities. Like in 2012, the Fed did not specify a total purchase amount or a specific timeline for purchases.
Effects of QE 1-3
By most measures, QE1 was the most effective of the three previous quantitative easing programs. After the announcement of the first quantitative easing program, the 10-year Treasury yield dropped 107 basis points in two days, demonstrating the short-term implications of quantitative easing.
Research on the effects of quantitative easing programs on the broader economy are contentious. Some estimates suggest that the first three quantitative easing programs led to a total addition of 2% to GDP. Other estimates vary widely on how the effects of quantitative easing programs impacted GDP. Research results on the impact of quantitative easing on inflation, stock prices, and consumer confidence are inconclusive.
One area where the effects of quantitative easing can be easily seen is in the mortgage market. According to the National Bureau of Economic Research, conforming mortgage origination increased 170% during QE1. QE2 focused only on Treasuries, but mortgage rates declined by about 35 basis points and new loan originations increased about 65%. QE3 saw loan rates fall by about 18 basis points and loan originations increased by 15 to 30%. The large-scale purchases of mortgage-backed securities also led to an increase in lending by banks that held large amounts of those securities prior to quantitative easing.
Since the Fed began using quantitative easing as a policy tool, the size of the Fed’s balance sheet has grown tremendously. During the first three rounds of quantitative easing, between 2007 and 2017, the Fed’s assets increased from $882 billion to $4.473 trillion. The most recent round of quantitative easing has added tremendously to the Fed’s balance sheet. Current Fed assets are over $8.5 trillion.
At November’s meeting, FOMC members announced a plan to reduce current asset purchases. This tapering plan will involve monthly reductions of $10 billion of Treasuries and $5 billion of mortgage-backed securities and is scheduled to conclude by the middle of next year. To learn more about how the economy may react to tapering, be sure to follow our social media accounts to be notified when we release the second article in this series: How Will Tapering of the QE Program Impact Rates and the Economy?
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