Impact of quantitative easing on US real economy and financial markets

Abstract

Before the 2007 crisis, monetary policies in countries had converged on an approach in whichthe stance was defined in terms of manipulating the short term interest rates which is known as‘interest rate policy’ i.e. the liquidity management operations are designed to meet the targetlevel of interest rates effective.Conventional monetary policies fail to create desired level of impact under few circumstances –few reasons can be when the country is facing? Deflationary environment coupled with slow down in the economy Near Zero interest rates prevailing the economy. The US balance-of-payments deficit with these nations has been widening over the years andmounting debts have plunged the Federal Reserve and Treasury to inflate the economy out ofdebt with a substantial increase in bank liquidity and credit—which means yet more debt. Thisin a way is flooding the global economy with electronic “keyboard” bank credit. This has seen aplunge in the exchange rates of the dollar and the money managers in the US with the cheapcapital available leading to the capital flow out of the domestic economy in search of safeinvestments.This additional capital which is being infused in the economy is not taking the form of any tangible assets or investments and hence results only in creation of debt. This policy of Quantitative Easing by the Fed has attracted debate on the effectiveness of the policy.The underlying assumption of the Fed to go ahead with such a policy is the fact that moreliquidity with the banks will help them lend credit at a mark-up which will bring earn them their way out of negative equity and re-inflate the economy. But the underlying assumption hasfailed to occur as the banks have become more cautious on their lending standards and also thebanks instead of domestic lending have begun to flood the global markets thereby leading tointerest rate arbitrages and currency speculations.We as a part of the study would want to delve deeper into these aspects and verify thecorrectness of the impact of Quantitative Easing.Hence, it can be said that when expansionary monetary policies fail to create an impact, theCentral Banks of such economies tend to introduce unconventional monetary policies in orderto stimulate an economy by purchasing large quantities of financial assets like long termsecurities and Mortgage backed securities from the banks. This unconventional policy measure is called Quantitative Easing. The objective of such a policy is to reduce the long term interestrates (via asset purchases which creates demand for debt) and stimulate the economy.Quantitative Easing is often understood by many as ‘printing money’ but the Central Banks donot print money but it electronically swaps assets with the private sector. That is it swapselectronically transferred money with interest bearing assets thereby increasing the liquidity inthe system. Subprime crisis in the US in 2007 was one of the reasons why the Federal Reserve had tointroduce Quantitative Easing. Prior to introduction of Quantitative Easing, the Federal Reserveheld between $700 – $800 billion treasury notes on its balance varying the amount to tweak themoney supply.The Fed in order to stimulate the economy lowered the interest rates from 5.25% (July 2007) to0.25% (Mar 2009). For detailed rate cuts, refer to table 1. Due to the availability of reserves and prevailing low interest rates started lending housing loans to subprime customers with no proper credit history. As a result there was a growing real estate bubble in the US economy.When large number of these customers failed to pay the loans, the real estate prices came down spiralling and there was a severe liquidity crunch in the economy. People started spending lessand the unemployment rates started increasing. The Federal Reserve was concerned that the sluggish economy would result in deflation and introduced a policy known as Quantitative Easing. Conventional monetary policies would not work in this case since the interest rateswere close to zero and further lowering of interest rates would result in liquidity trap situation.The objective of such a policy was that, when the Feb buys securities from the banks it wouldresult in an increase in the reserves of the bank. The banks would in turn use the extra credit tolend more loans which would have a multiplier effect on the economy and bring the nation outof recession.Our study would test if such a policy measure by the Federal Reserve helped the US to revive itseconomy.