The phrase Quantitative Easing (QE) was first introduced in the 1990s as a way to describe the Bank of Japan’s (BOJ) expansive monetary policy response to the bursting of that country’s real estate bubble and the deflationary pressures that followed. Since then, a number of other major central banks, including the U.S. Federal Reserve, the Bank of England (BoE) and the European Central Bank (ECB), have resorted to their own forms of QE. Although there are some differences between these central banks’ respective QE programs, we'll look at how the Federal Reserve’s implementation of QE differs from its more conventional Open Market Operations (OMO), with the main difference having to do with the scale of asset purchases.
The Fed’s Objectives
The Federal Reserve is responsible for the implementation of monetary policy in adherence with a set of objectives established by Congress. These objectives include maximum employment, price stability and moderate long-term interest rates. (For more, read: The Federal Reserve: Introduction.)
Maximum employment can be interpreted as the level of employment at which prices remain stable. Any attempt to push employment above, or unemployment below, the target threshold could lead to rapidly-increasing wages that in turn could easily carry over into rapidly-increasing prices throughout the economy.
Price stability and moderate long-term interest rates are essentially objectives that aim to avoid both excessive inflation and deflation. Price stability is generally regarded as being achieved when prices increase gradually. As the real interest rate– nominal interest rate minus inflation rate – is the true cost of borrowing money, inflation expectations are crucial for setting long-term nominal interest rates. By keeping expectations of inflation low, the Fed can effectively achieve moderate long-term interest rates.
Following a meeting in January 2012, the Federal Open Market Committee (FOMC) determined that aiming for an inflation rate of 2% would be the most appropriate way to meet its objectives. The primary way the Fed achieves this target is through manipulation of the fed funds rate—an overnight rate at which banks and other depository institutions lend to each other – and it generally does this through OMO.
Open Market Operations
OMO consist of the Fed either expanding or contracting its balance sheet by either buying or selling Treasury bonds on the open market. By either buying or selling government securities, the Fed affects the level of reserves within the banking system. Buying securities increases reserves; selling decreases them.
Tight monetary policy that involves decreasing the level of reserves will begin to put downward pressure on banks’ ability to lend to one another and consequently cause an increase in the fed funds rate. As this increase in the fed funds rate becomes an additional cost to banks, they will incorporate it into their rate-setting policies, causing an increase in economy-wide interest rates.
In a booming economy with upward pressure on price levels, a tight monetary policy operation can help to keep things from overheating. The opposite is the case when the Fed uses a loose monetary policy to increase the level of reserves, bringing down the interest rate and hopefully stimulating a sluggish economy that's experiencing deflationary pressures. Yet in severe crises, loose monetary policy can be limited by the zero lower bound of interest rates.
The Zero Lower Bound
In severe crises, like the U.S. experienced in 2008, a loose or expansionary policy can be limited by the fact that interest rates can't theoretically be lower than zero. While it's possible in practice, as the ECB has recently experimented with negative interest rates, it's generally assumed that pushing below zero the rate that depository institutions must lend to each other will be ineffective in affecting economy-wide interest rates. This is because depositors, rather than pay the negative interest rate required to hold their money at the bank, can instead withdraw it and hold it in the form of pure cash. So this situation could have the opposite effect than was intended, as it decreases the amount of money banks have to lend and thus pushes up interest rates instead of bringing them down.
When interest rates are approaching zero and the economy is still in the doldrums, the conventional monetary policy of OMO becomes ineffective. In such a situation, more drastic or unconventional measures are implemented. Recently, QE has been the go-to option for a number of central banks in the aftermath of the 2008 global financial crisis.
The key to understanding QE is in its name. "Easing," similar to the use of "loose" in "loose monetary policy," evokes the idea of easing monetary conditions and making it cheaper to borrow money. While QE is really just an extension of expansionary OMO, "quantitative" implies that the size or scale of the policy is essentially where the difference lies.
First of all, where OMO restricted itself to shorter-term government securities, the Fed’s QE asset purchases included longer-term government securities as well as mortgage-backed securities (MBS). Thus rather than focusing solely on affecting short-term interest rates, the Fed’s purchase of longer-term securities meant that it was directly attempting to bring down longer-term rates as well.
Secondly, while OMO focuses on targeting the fed funds rate and is less concerned with the overall amount of reserves, the Fed’s QE program was administered with the intention of injecting a massive amount of reserves into the banking system. Accomplishing this meant making enormous asset purchases. After three rounds of QE, the Fed had more than quadrupled the size of its balance sheet. (For more, read: Quantitative Easing: Does It Work?)
The Bottom Line
While OMO is generally effective at influencing interest rates in normal times, in severe crises it becomes inert. Here is when central banks have desperately turned to the unconventional monetary policy of QE to essentially have a mass injection of reserves into the banking system. Yet the jury is still out on whether these injections have been effective in stimulating economic growth. In times of crisis, people, no less than banks, can be hesitant to let money go out of their hands. Without having a clear increased source of effective demand, it's not evident that simply increasing the amount of money in the economy accomplishes anything.