Quantitative Easing and Tightening Explained
What is Quantitative Easing (QE)?
Quantitative easing (QE) is a monetary policy tool used by a central bank (i.e. the Federal Reserve) to stimulate the economy in times of crisis. It increases market liquidity and lowers long-term interest rates. QE acts as a monetary stimulus and is utilized when interest rates are high and economic activity is slow.
Quantitative easing occurs when a central bank buys long-term securities from its member banks. By buying these securities, the central bank adds new money to the economy; as a result of the influx, interest rates fall, making it easier for people to borrow.
How Does Quantitative Easing Work?
The Federal Reserve buys securities from its member banks, giving them cash in exchange for assets such as bonds. The cash given to banks is then able to be lent out. The Fed manages the banks’ reserve requirements. This dictates how much of their funds are required to keep on hand vs. how much they can lend out.
Lowering the reserve requirement allows banks to lend out more money, increasing the supply of money in circulation. Increasing the supply of money allows interest rates to fall. Lower interest rates incentivize people to borrow and spend, which should stimulate the economy in return.
Does Quantitative Easing Cause Inflation?
One downside is that quantitative easing increases the Fed’s holdings of Treasurys and other securities. For example, before the 2008 financial crisis, the Fed’s balance sheet held less than $1 trillion. By July 2014, that number had increased to almost $4.5 trillion.
The more dollars the Fed creates, the less valuable existing dollars are. Over time, this lowers the value of all dollars, which then buys less. The result is inflation.
Inflation doesn’t occur until the economy is thriving. Once that happens, the assets on the Fed’s books increase as well. The Fed would have no problem selling them. Selling assets would reduce the money supply and cool off any inflation
When Has Quantitative Easing Been Used?
The Fed used quantitative easing in the wake of the 2008 financial crisis to restore stability to financial markets. In 2020, in the wake of the financial fallout of the COVID-19 pandemic, the Fed once again leaned on quantitative easing, growing its balance sheet to $7 trillion.
In 2008, the Fed launched four rounds of quantitative easing to fight the financial crisis from December 2008 to October 2014, adding almost $4 trillion to the money supply. The Fed was forced to resort to quantitative easing because other expansionary monetary policy tools were ineffective. The Fed funds rate and the discount rate were zero.
That remained the largest expansion from an economic stimulus program in US history until 2020 in response to the COVID-19 pandemic. On March 15, 2020, the Fed announced it would purchase $500 billion in U.S. Treasurys. It would also buy $200 billion in mortgage-backed securities over the next several months.
On March 23, 2020, the FOMC expanded quantitative easing purchases to an unlimited amount. By May 18, its balance sheet had grown to $7 trillion. Fed Chair Jerome Powell said he was not concerned about the increase to the Fed’s balance sheet.
Has Quantitative Easing Been Successful?
In the examples above, quantitative easing achieved some of its goals while missing some others. In the 2008-2014 round of quantitative easing, it removed subprime mortgages from banks’ balance sheets which restored banking operations, as well as stabilized the US economy by providing the funds to pull out of the recession. quantitative easing also kept interest rates low enough to revitalize the housing market, almost a full percentage point.
While quantitative easing helped stimulate US economic growth and lower interest rates, it also lead to asset bubbles by cheapening the dollar. An asset bubble refers to the dramatic increase in the price of an asset that is not supported by the underlying value of the said asset. For example, the housing bubble spurred by quantitative easing caused home prices to rise, not correlated to the actual values of the homes.
What is Quantitative Tightening (QT)?
Quantitative tightening is essentially the opposite of quantitative easing. Also known as balance sheet normalization, QT means reducing the supply of reserves. A central bank sells its balance sheet assets, basically all the bonds on its balance sheet at the moment, and reduces the money supply circulating in the economy.
Through quantitative tightening, the Fed reduces its supply of monetary reserves to tighten its balance sheet. It accomplishes this by either selling assets or letting them reach maturity. When this happens, the Treasury department removes them from cash balances, and thus the money it has “created” by buying the securities has effectively disappeared.
Quantitative Tightening in 2022
The Federal Reserve released its plan for quantitative tightening on May 4th. The plan announced that the Fed would begin draining bank reserves from its nearly $9 trillion balance sheet starting on June 1, 2022.
Inflation has reached decades high in 2022, led by fallout from the COVID-19 pandemic. In March 2020, the Fed cut the Fed Funds rate to 0.00%-0.25% in response to the pandemic, along with utilizing quantitative easing monetary policy.
During the pandemic, the Fed’s asset holdings more than doubled from $4.2 trillion to $8.9 trillion. That figure stopped growing in April 2021 after the Fed completed a “taper” of those purchases. Now starting in June, the Fed will be shrinking the balance sheet at a maximum monthly pace of $60 billion in Treasuries and $35 billion in mortgage-backed securities.
As quantitative tightening takes money out of the financial system, theory indicates that borrowing costs should rise, just as quantitative easing drives interest rates lower. Because the Fed had already announced a steep trajectory of interest-rate hikes in coming months, the interest rate has already begun to surge. Ten-year Treasury yields in May went above 3% for the first time since 2018.
Quantitative Easing vs. Quantitative Tightening
Quantitative easing and tightening are both monetary policy tools utilized by a nation’s central bank (i.e. the Federal Reserve) to promote sustainable economic growth. Monetary policy refers to the policy that controls the overall supply of money that is available to the nation’s banks, consumers, and businesses.
The US Treasury Department is the governing body with the ability to create money, but the Fed uses policy tools to influence the supply of money in the economy, largely through open market operations (i.e. buying or selling financial securities). The goal is to keep the economy running at a maintainable rate.
Quantitative easing means a central bank buys bonds to drive down long-term interest rates and slow economic growth. Quantitative tightening means a central bank reduces the supply of money in the hopes of slowing inflation and raising rates.
QE is a form of expansionary monetary policy, meaning it is aimed at expanding economic activity at a time of high unemployment or a recession. QT is a form of contractionary monetary policy, meaning it is aimed at slowing inflation and the growth of the money supply.
How Does Monetary Policy Impact Investments?
Central bank actions can have a significant impact on the financial markets, including investments.
For example, if the Fed increases the money supply through lowering interest rates, it can lead to lower borrowing costs and increased liquidity in the financial markets. This can make it easier for investors to access capital and potentially drive up asset prices, including the prices of investments such as stocks and bonds.
On the other hand, if a central bank tightens monetary policy by raising interest rates or reducing the money supply, it can lead to higher borrowing costs and reduced liquidity in the financial markets. This can make it more difficult for investors to access capital and potentially drive down asset prices.
Protect Against Interest Rate Risk
In the current economic climate, with financial markets in bear territory and interest rate hikes continuing it can be useful to understand which investments help to protect against the risks of monetary policy changes.
Contemporary Art is one alternative asset that provides portfolio diversification away from traditional markets and helps to hedge against inflationary pressures and reduced liquidity in financial markets.
The last time inflation was near 2022 levels, Fine Art had an average annual appreciation of 33%, according to the Masterworks All Art Index.
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This post is for informational and educational purposes only. It is not intended for nor should it form the basis of an investment decision.