Open Market Operations vs. Quantitative Easing: An Overview
The U.S. Federal Reserve was created by the Federal Reserve Act in 1913. The Federal Reserve is the central banking system of the United States of America. It has central control of the U.S. monetary system in order to alleviate financial crises. Since its establishment, the Fed, as it is often called, has been responsible for a three-part mandate: maximizing employment, stabilizing prices, and monitoring interest rates. Since 2012, the Fed has mostly targeted a 2% inflation rate, which it uses as a guide for price movement.
The Fed follows the labor market’s employment capacity and analyzes unemployment along with wage growth in correlation with inflation. The Fed also has the ability to effectively influence interest rates on credit in the economy, which can have a direct effect on business and personal spending.
With the responsibility and authority to take action in these three key areas, the Fed can deploy several tactics. Here, we will discuss two of those: open market operations and quantitative easing (QE).
- Open market operations are a tool used by the Fed to influence rate changes in the debt market across specified securities and maturities.
- Quantitative easing is a holistic strategy that seeks to ease, or lower, borrowing rates to help stimulate growth in an economy.
- Open market operations can obtain the goals and objectives of quantitative easing if an economy is not in crisis.
Open Market Operations
The Federal Open Market Committee has three main tools that it uses to achieve its three-part mandate. Those actions include: open market operations, setting the federal funds rate, and specifying reserve requirements for banks.
For an open market operations strategy, the central bank will create money and buy short-term Treasury securities from banks, individuals, and institutions in the open market. This creates demand for the securities, increasing the price and decreasing their yield. The demand for securities injects money into the banking system, which is then loaned to businesses and individuals, and puts downward pressure on interest rates. This boosts the economy because businesses and individuals have more money to spend.
Quantitative Easing (QE)
A QE strategy is often employed during a crisis and when open market operations have failed. For example, the interest rate may already be at zero, but there is still a slowdown in lending and economic activity. In such situations, the central bank might buy a variety of securities to revive them: long-term treasuries, private securities, or securities in a particular area of the market.
The idea is to again boost economic activity, introduce money into the system, lower the yield, and ease out specific markets, such as mortgage-based securities, by reducing the risk spread. QE increases the central bank's balance sheet considerably and exposes it to greater risk.
Examples of Quantitative Easing
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 the nation'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, here's how the Federal Reserve’s implementation of QE has been effective.
The 2008 Financial Crisis
QE was used following the 2008 financial crisis to improve the health of the economy after widespread subprime defaults caused major losses resulting in broad economic damage. In general, policy easing refers to taking actions to reduce borrowing rates to help stimulate growth in the economy. Keep in mind, quantitative easing is the opposite of quantitative tightening which seeks to increase borrowing rates to manage an overheated economy.
From September 2007 through December 2018, the Federal Reserve took quantitative easing steps, reducing the federal funds rate from 5.25% to 0% to 0.25%, where it stayed for seven years. In addition to decreasing the federal funds rate and holding it at 0% to 0.25%, the Fed also used open market operations.
In this case of quantitative easing, the Fed used both federal funds rate manipulation and open market operations to help reduce rates across maturities. The federal funds rate reduction focused on short-term borrowing, but the use of open market operations allowed the Fed to also decrease intermediate and longer-term rates as well. As mentioned, buying debt in the open market pushes prices up and rates down.
Large-Scale Asset Purchases from 2008 to 2013
The Fed implemented large-scale asset purchases in multiple rounds from 2008 to 2013:
- November 2008 to March 2010: purchased $175 billion in agency debt, $1.25 trillion in agency mortgage-backed securities, and $300 billion in longer-term Treasury securities.
- November 2010 to June 2011: purchased $600 billion in longer-term Treasury securities.
- September 2011 through 2012: Maturity Extension Program—purchased $667 billion in Treasury securities with remaining maturities of six years to 30 years; sold $634 billion in Treasury securities with remaining maturities of three years or less; redeemed $33 billion of Treasury securities.
- September 2012 through 2013: purchased $790 billion in Treasury securities and $823 billion in agency mortgage-backed securities.
After four years of holding the new assets on the balance sheet, the Fed’s QE goals had reportedly been achieved and were markedly successful. As such, the Fed began the process of normalization in 2017 with an end to principal reinvestments. In the years following 2017, the Fed plans to use open market operations in somewhat of a tightening mode with staged plans for selling balance sheet assets in the open market.
Open Market Operations and Quantitive Easing In Response to the COVID-19 Pandemic
The Fed took drastic action in terms of both open market strategy and QE to bolster the U.S. economy after the outbreak of the COVID-19 epidemic in 2019.
For open market strategy, the Fed supplied $2.3 trillion in lending to support households, employers, financial markets, and state and local governments. The Fed cut the target federal funds rate to 0% to 0.25% in March 2020 to lower the cost of borrowing on
mortgages, auto loans, home equity loans, and other loans. However, the effect would also reduce the interest income paid to savers.
As part of its QE strategy, the Fed purchased massive amounts of securities. In March 2020, the Fed announced that it would buy at least $500 billion in Treasury securities and $200 billion
in government-guaranteed mortgage-backed securities over “the coming months.” According to Brookings, on March 23, 2020, the Fed "made the purchases open-ended, saying it would buy securities 'in the amounts needed to support smooth market functioning and effective transmission of monetary policy to broader financial conditions.'"
Market function subsequently improved, and the Fed decreased its purchases through April and May. On June 10, 2020, however, the Fed said it would buy $80 million a month in Treasuries and $40 billion in residential and commercial mortgage-backed securities. Between mid-March and early December of 2020, the Fed’s portfolio of securities grew from $3.9 trillion to $6.6 trillion.
Many other programs were instituted by the Fed including the Primary Dealer Credit Facility (PDCF), a legacy of the global financial crisis, which offered low-interest rate (currently 0.25%) loans up to 90 days to 24 large financial institutions known as primary dealers. The goal was to keep credit markets afloat.
The Fed also took other steps such as backstopping money market mutual funds. It encouraged banks to lend by lowering the rate that it charges banks for loans from its discount window by 2 percentage points, from 2.25% to 0.25%, lower than during the Great Recession. The Fed supported corporations and businesses through direct lending through the Primary Market Corporate Credit Facility (PMCCF).
Many other new programs were implemented to supporting loans to small- and mid-sized businesses, such as the Main Street Lending Program and the Paycheck Protection Program. The Fed supported households and consumers with the Term Asset-Backed Securities Loan Facility.
Lastly, the Fed has attempted to cushion U.S. money markets from international pressures by making U.S. dollars available to other central banks. The Fed gets foreign currencies
in exchange, and charges interest on the swaps. According to Brookings, "five foreign central banks have permanent swap lines with the Fed, and the Fed has cut the rate it charges on those swaps with central banks in Canada, England, the Eurozone, Japan, and Switzerland, and extended the maturity of those swaps. It also extended temporary swaps to the central banks of Australia, Brazil, Denmark, Korea, Singapore, and Sweden."
The Bottom Line
In summary, the main difference between open market operations and QE is the size and scale of the actions taken by the Fed. QE typically requires a heavy investment that significantly increases the central bank's balance sheet. Also, while open market operations target interest rates as part of the strategy, QE targets and increases the amount of money in circulation.