Understanding the Fed: How Quantitative Easing Works

Previous entries in our series on understanding the Federal Reserve (Fed) looked at what a central bank does and how the Fed uses the federal funds target rate – one of its top conventional policies – to influence the direction of the broader economy. More recently, we looked at how the Fed uses open market operations to keep the federal funds rate within its target range.

Now let’s dig more deeply into another of the Fed’s monetary policy tools: quantitative easing (QE) – or buying and selling of long term securities to affect long-term interest rates and thereby, economic activity.

QE is an unconventional monetary policy aimed at stimulating the economy. You may have seen it mentioned in the news, but if you’re like a lot of people, you may not understand what it is or how it works. Let’s take a closer look.

During the last U.S. recession, which began in 2007, the federal government deployed a series of policy moves in an effort to counteract the downturn. (For a look at the broad range of actions taken by the Fed in its response to the financial crisis, please take a look at the Fed’s crisis response page on its website.)

Congress and the executive branch sought to boost the economy using the traditional tools of fiscal policy-stimulus spending and tax reductions.

The Federal Reserve, responsible for monetary policy, initially focused on ensuring liquidity in the economy by cutting its target federal funds rate to historically low levels.

But the extraordinary depth and breadth of the 2007-2009 recession called for additional measures. With the economy on the brink and the federal funds rate already near zero, the Fed needed a new approach to boost demand in the economy.

The Fed’s then-chairman, Ben Bernanke, made the case for a course of quantitative easing through large-scale asset purchases. (You might also see QE referred to as “credit easing,” which was Bernanke’s preferred description).

Here’s how QE worked. The Fed announced in advance that it would make large-scale asset purchases on the open market.

So beginning in 2009, and for several years thereafter, the Fed bought Treasury, mortgage-backed and other agency securities in large quantities on a regular schedule. That had the effect of driving up the price of those long-term securities, which as we explained in How the Fed Maintains Interest Rates in turn lowered their yields and long-term interest rates in the market generally.

Those purchases also put more cash in the hands of lenders, which reduced the cost of borrowing further. With more credit available at lower rates, businesses could finance capital investments like new equipment and buildings – which helped boost economic growth and created jobs. At the same time, individuals could finance home buying (or refinance at lower rates), another critical component of economic recovery.

It’s important to note that while QE is an unusual strategy, it’s not new. As the St. Louis Fed noted in an explainer on QE, “it was used by the Fed in the 1930s, the Bank of Japan in 2001 and more recently by the Bank of England.” More recently, the European Central Bank (ECB) began its own rounds of QE in March 2015.

Here’s how QE worked. The Fed announced in advance that it would make large-scale asset purchases on the open market.

So beginning in 2009, and for several years thereafter, the Fed bought Treasury, mortgage-backed and other agency securities in large quantities on a regular schedule. That had the effect of driving up the price of those long-term securities, which as we explained in How the Fed Maintains Interest Rates in turn lowered their yields and long-term interest rates in the market generally.

Those purchases also put more cash in the hands of lenders, which reduced the cost of borrowing further. With more credit available at lower rates, businesses could finance capital investments like new equipment and buildings – which helped boost economic growth and created jobs. At the same time, individuals could finance home buying (or refinance at lower rates), another critical component of economic recovery.

It’s important to note that while QE is an unusual strategy, it’s not new. As the St. Louis Fed noted in an explainer on QE, “it was used by the Fed in the 1930s, the Bank of Japan in 2001 and more recently by the Bank of England.” More recently, the European Central Bank (ECB) began its own rounds of QE in March 2015.

The U.S. economy has substantially recovered since the recession ended in 2009, with unemployment gradually returning to near pre-crisis levels and an improved outlook across a wide range of indicators. Does that mean QE worked? The question is more difficult to answer than you might think.

Supporters of QE would say “yes.” From their perspective, the Fed’s strategy, unconventional though it may have been, served to inject much needed liquidity into a contracting economy, stimulating greater demand and helping to restore stability. Given that the economy has gradually strengthened and employment has returned to normal levels, this may be a compelling argument, even if the recovery has been slower than desired.

But it’s not the end of the story, as critics argue that since improved economic conditions would have emerged regardless of the Fed’s actions, the QE strategy was ineffectual and wasteful.

Criticism of the QE strategy has even come from some leaders within the Fed. Stephen D. Williamson, a vice president at the St. Louis Fed, argues that QE had at best a “tenuous link” to the improved economy.

Some of the critics’ early warnings about QE’s risks, like the danger of higher inflation, have not come to pass. But economists will no doubt continue to sift the evidence and debate the merits and demerits of how QE affected the economy-and it may be too soon to say what ultimate impact the program will have had, since its effects are complex and far-reaching.