How Quantitative Easing Stimulates the Economy

Federal Reserve Chairman Jerome Powell holds a news conference following the two-day meeting of the Federal Open Market Committee meeting on interest rate policy in Washington, D.C., January 29, 2020. (Yuri Gripas/Reuters)
The Fed is entering this recession with no conventional tools at its disposal.

NRPLUS MEMBER ARTICLE T he Fed announced its fourth round of quantitative easing (QE) on Sunday. In addition to cutting the benchmark interest rate to zero, the Fed will purchase $700 billion worth of Treasuries and mortgage-backed securities with two aims: 1) boosting liquidity in the financial system; 2) increasing aggregate demand by expanding the money supply.

Central banks have intermittently purchased assets from financial institutions since roughly 1990, when the Swedish and Finnish central banks undertook quantitative easing in response to the Nordic banking crisis. In 2000, the Bank of Japan was the first major-economy central bank to conduct asset purchases. The Federal Reserve and Bank of England followed suit after the 2008 financial crisis.

Under Chairman Ben Bernanke, the Fed initiated its first round of QE (“QE1”) in December of 2008 and followed up with two subsequent rounds until suspending asset purchases in December 2014.

Zero Lower Bound

Traditionally, central banks have conducted monetary policy by setting the policy interest rate. In the U.S., that’s called the federal funds rate. By decreasing rates, the Fed spurs borrowing, which increases the money supply. With more money in the economy, consumers will theoretically spend more, and businesses can invest at a lower cost. Conversely, the Fed increases rates in order to reduce the risk of inflation when the money supply grows too large.

But when the policy rate hits the “zero lower bound,” the Fed can’t stimulate the economy through conventional means. That’s what happened in 2008, when the Fed cut the federal funds rate to zero during the deepest recession since the Great Depression, and it’s happening again.

 

The Role of Unconventional Tools

When a central bank hits the zero lower bound, it has to turn to unconventional monetary tools or risk letting the economy fall into an uncontrolled recession. Unconventional tools include QE, as well as forward guidance (forecasting future interest-rate changes), negative interest rates (charging banks to hold reserves at the central bank), and “helicopter money” (transferring money directly to consumers). Alternatively, academics and practitioners have advocated broader structural changes to the monetary regime — such as increasing the inflation target or targeting a different metric (e.g., nominal income) — to combat the zero-lower-bound conundrum. While the Fed has limited its unconventional tools to QE and forward guidance, the European Central Bank has instituted negative interest rates as well.

By purchasing assets from banks, the Fed increases banks’ holdings in cash as opposed to financial securities. That expands the total currency in circulation and the availability of credit, which increases aggregate demand. Before 2008, the monetary base (the sum of currency in circulation and deposits held at the central bank) expanded at a relatively stable, constant rate. But QE increased the monetary base at an unprecedented rate.

 

Actual Inflation/Inflation Expectations

Partially as a result of QE, inflation expectations remained above 2 percent throughout the crisis, despite a precipitous fall in actual inflation. If consumers expect low inflation (or worse, deflation), they will increase savings relative to consumption. Low inflation expectations can spur a self-fulfilling prophecy in which the belief that prices will fall curbs consumer spending, thereby causing a drop in prices and exacerbating a recession. So asset purchases not only increase the money supply today, they increase consumers’ willingness to spend by elevating inflation expectations. All of this amounts to a jolt for the economy, but it comes with costs.

 

Blue line: Year-over-year increase in consumer prices (quarterly)
Black-dotted line: Anticipated change in consumer prices over the next twelve months (quarterly)

 

 Challenges

Proponents believe that the stimulus transmitted through asset purchases contributed to the recovery of the U.S. economy after 2008, but critics argue that it could lead to hyperinflation. That has yet to materialize; in fact, inflation has often been below the Fed’s 2 percent target over the past few years. But research suggests that the efficacy of asset purchases depends on a central bank’s credible commitment to unwind its balance sheet afterward. Since ending QE in 2014, the Fed has sold only a small portion of its assets. It remains to be seen whether a further expansion of the balance sheet will have an inflationary effect.

 

Others say that asset purchases effectively subsidize banks while consumers continue to struggle. On one hand, it is true that banks benefit from asset purchases, as they get access to much-needed cash at times of stress. On the other hand, the financial system is the most effective way to channel credit to consumers. Indeed, mortgage-backed-security purchases directly decrease borrowing costs for households.

What’s certain is that we are in the midst of a massive economic experiment. After a decade of near-zero interest rates, the Fed enters this recession with no conventional tools at its disposal. Couple that with massive government debt and deficits, and federal efforts to combat the crisis will need to be nothing short of inspired.

Most Popular

Culture

Thank You, Kanye West

It was “a plan by the Devil to have our kids committing suicide at an all-time high.” So said Kanye West, who recently declared, via Twitter, that he was running for president, on the “Birthday Party” ticket. It’s about the best explanation I’ve heard for the non-coronavirus that plagues us. There’s ... Read More
Culture

Thank You, Kanye West

It was “a plan by the Devil to have our kids committing suicide at an all-time high.” So said Kanye West, who recently declared, via Twitter, that he was running for president, on the “Birthday Party” ticket. It’s about the best explanation I’ve heard for the non-coronavirus that plagues us. There’s ... Read More
Education

The Case for Reopening Schools

On the menu today: My reader who is the head of research for a top-ten hospital weighs in on how to get kids back into classrooms safely this fall, a blathering Biden comment I missed that could have gotten his Twitter account suspended, and California’s state government tries to implement an ambitious ... Read More
Education

The Case for Reopening Schools

On the menu today: My reader who is the head of research for a top-ten hospital weighs in on how to get kids back into classrooms safely this fall, a blathering Biden comment I missed that could have gotten his Twitter account suspended, and California’s state government tries to implement an ambitious ... Read More
Science & Tech

The Ideological Corruption of Science

Why don't many people “trust the science” anymore? Perhaps because science, as an institution, has fallen prey to the same ideological infection that has invaded and corrupted many other institutions. But it is too rarely discussed, which is why a Sunday Wall Street Journal column by theoretical physicist ... Read More
Science & Tech

The Ideological Corruption of Science

Why don't many people “trust the science” anymore? Perhaps because science, as an institution, has fallen prey to the same ideological infection that has invaded and corrupted many other institutions. But it is too rarely discussed, which is why a Sunday Wall Street Journal column by theoretical physicist ... Read More
Culture

In Defense of Terry Crews

There are many worthy nominees for the craziest moment in the current cultural turmoil, but the controversy over tweets by actor Terry Crews deserves to be high on the list. In one of his offending tweets, Crews said on July 4th: https://twitter.com/terrycrews/status/1279493774679261185?s=21 It wasn’t ... Read More
Culture

In Defense of Terry Crews

There are many worthy nominees for the craziest moment in the current cultural turmoil, but the controversy over tweets by actor Terry Crews deserves to be high on the list. In one of his offending tweets, Crews said on July 4th: https://twitter.com/terrycrews/status/1279493774679261185?s=21 It wasn’t ... Read More
Science & Tech

Evaluating Fauci’s Record

The White House is getting a lot of heat by pointing out that Dr. Anthony Fauci, the country’s top infectious-disease official, has a spottier record on predicting the course of pandemics than the media would have you believe. “White House officials now want to rein in Fauci by cherry-picking instances in ... Read More
Science & Tech

Evaluating Fauci’s Record

The White House is getting a lot of heat by pointing out that Dr. Anthony Fauci, the country’s top infectious-disease official, has a spottier record on predicting the course of pandemics than the media would have you believe. “White House officials now want to rein in Fauci by cherry-picking instances in ... Read More