Roosevelt Institute | Cornell University

Easing Quantitative Easing

By Hamdan Al YousefiPublished November 9, 2014

Quantitative Easing has pumped trillions of dollars into the economy, acting as a lifeline during the recession. But as the Fed announces its intentions to stop the supplement it is questionable how the economy will react.

By Hamdan Al Yousefi, 11/9/14

The Federal Reserve has recently announced the termination of Quantitative Easing — an economic ‘experiment' that began in 2008. While the effects of Quantitative Easing will take time to clarify, questions can be raised as to why the Fed has decided to shut down the project when it seems to be producing positive results.

Quantitative Easing is a monetary policy tool first used by Japan in the early 2000s to fight deflation and has since been adopted by the Federal Reserve, the Bank of England and the European Central Bank in their attempts to recover from the economic crisis by adjusting the money supply.

The policy involved the creation of cash by the Federal Reserve, which was then used to purchase a variety of government and mortgage bonds to the sum of $85bn a month. Theoretically, banks would then use the increase in assets to purchase new securities — securities that will have seen a price increase due to the government already buying up a large quantity. With more assets to their names, banks are more willing to make loans, decreasing interest rates, increasing confidence and boosting economic activity.

In the last five years, the Fed has made $3 trillion worth of asset purchases, taking its current balance sheet to $4 trillion. The policy has arguably been a successful one, though others may disagree.

The Fed has two main goals: maintain stable inflation and employment levels, and it achieves this goal through interferences in the financial market. Since QE, mortgage rates have gone from a high of over 6% to a low of 3.3% in 2013. This represents a huge cost decrease for most American families, removing the premium most have to pay on mortgages. Inflation levels have gone from -1% pre QE to hovering around the target rate of 2%. The economy is growing at a steady rate and for the first time since 2008 unemployment has dropped below 6% - a natural consequence of the increased growth rate that QE has brought on.

It can be argued that the results attained from QE have not been proportionate to the investment put in ­­ ­— with around $3 trillion dollars spent the economy is still not at pre-recession levels and GDP is far from its potential. However when then chairman of the Fed Ben Bernake announced the ‘tapering' of QE last year — reducing the monthly purchase of securities — the market was rocked by the news, suggesting that investor confidence in the USA is still shaky.

Reports suggest that for every 1% of GDP the Fed spent on bonds, real output and inflation increased by one-third percent — a large amount when you realize that inflation hovers at around 2%. As such the effects of QE cannot be understated — particularly when interests rates are still near zero.

There is a very real chance that the economy will collapse without the support of QE — price levels and output will fall, followed shortly by rises in unemployment. As the interest rate cannot be lowered even further in an attempt to stimulate the economy, chances are the Fed will have to resort to another round of QE.

According to Janet Yellen, current chairwoman of the Fed, even if the economy was to improve without QE, the Fed would not be selling off its assets, rather controlling the money supply through interest rates. It seems like the removal of QE will not even have a positive impact on the Fed's balance sheet.

QE has also not seen any of the negative side effects that had been predicted prior to its implementation — namely hyperinflation. There were genuine fears that banks would not be able to control the circulation of their increased reserves creating very high and uncontrollable levels of inflation. However regulatory banking measures do exist that can control inflation and any undue risk-taking by investors.

QE has not been perfect. The lowered interest rates have strongly favored younger borrowers over older savers — particularly due to the Fed's intervention in the housing market, rather than just persisting with government bonds. The lowered interest rates have encouraged excessive risk taking and the increase in stock prices has increased inequality, strongly benefitting the rich.

The main reason the Fed seem to have announced the end of Quantitative Easing seems to be because of the improvement in the economy. The worst of the recession seems to be past us and so it follows that the very artificial — and controversial — policy of QE be put to bed. Elongating the policy could lead to inflation and asset bubbles — in the eyes of the Fed it is best to slam the brakes as quickly as possible.

But from a wider perspective, QE has also created jobs, dispelling some of the myths about inequality. It has stabilized output and increased inflation and when tapering measures were taken, interest rates around the world spiked. It's hard to say how the economy will deal without the QE stimulus or what the long term effects will be, however it doesn't seem rational to stop a policy that seems to be acting as a lifeline to the economy and has so far been successful.

The removal of QE may lead to increased investor confidence — we do not know what the longer-term consequences are going to be. But if the results of the tapering process are to be used as the basis of investor reaction, then the immediate removal of the program may not bode well for the economy.