Does Quantitative Easing Work

Quantitative easing is a term used to describe a form of economic stimulus offered by the Federal Reserve Bank to help boost market activity including business lending. This type of economic aid is an alternative to government funded investments, tax breaks and subsidizing. In the case of the U.S. Government, as of October, 2010, deficit spending has become so high that it has reached levels near that of World War II and the Great Depression. Hence, the assistance of the Federal Reserve Bank is seen as a viable alternative to increase business and lending activity. This however, may not be as beneficial to business and market activity as some predict for more than one reason.

The first reason quantitative easing by the Federal Reserve might not be as helpful as intended is method. On October 27, 2010, reports that the U.S. Federal Reserve bank would only place hundreds of billions of dollars into the economy via treasury purchases over three months caused concern. This is due in part to market psychology, and second, due to actual quantitative availability of funds for potential lending, spending and investment. Skeptics became concerned that a gradual and cautious approach to a second round of Federal spending in a way that did not mirror an earlier version was not the amount priced into market values.

Another reason why quantitative easing from the Federal Reserve Bank may not be as helpful to the U.S. Economy as expected is asset management. That is to say, if the balance sheet of large banks to whom federal funds will be available do not see good reason to spend, then they might not. This is evident in the early 2000’s Japan pumped billions of dollars worth of Japanese Yen into its economy via a quantitative easing program of its own. However, the quantitative easing excluded the desired effect of strong economic stimulus. The reason for this according to a Federal Reserve report by Takeshi Temura and David Small was because of cautious asset management on behalf of banks i.e. financial intermediaries that didn’t want to take on additional risk to their already risk tainted asset portfolios.

According to an October 27, 2010 MarketWatch interview with Jon Hilsenrath, a writer for the Wall Street Journal, when the Federal Reserve buys bonds via a quantitative easing program, it has an equivalent  affect as lowering the Federal Funds rate by 50-75 basis points or between .5-.75 percent. Since the Federal Funds rate was .25 percent in October, 2010, that would be similar to the effect of a negative interest rate in which the potential yields that banks could obtain from borrowing money would rise due to low cost. Instead, the larger availability of money is intended to increase market prices by encouraging demand. With higher market prices, comes a theoretical greater wealth, or wealth like affect on the economy.

In light of the above reasons, whether or not quantitative easing by the Federal Reserve bank will be helpful to the market depends on banking decisions in addition to borrowing activity. Without bank investment or increased lending activity, the intended purpose of quantitative easing may not be accomplished. Banks existing assets need to perform well enough to justify additional risk taking or additional risk taking has to be low enough to offset existing risky assets. If financial institutions decide the increased availability of money is to their advantage, they may see opportunities somewhere if not domestically, that on a medium to long-term time horizon may yield economy friendly banking profits.

Sources: (Date of record, October 27, 2010)

1.  (Wall Street Journal)
2. (Federal Reserve)
3.   (Federal Reserve Statistical Release)
4.   (MarketWatch)