Quantitative Easing 2

Quantitative easing (QE) is when a central bank shifts its focus to expanding its balance sheet through the purchase of longer-term securities rather than targeting short-term interest rates. Under QE, central banks inject the banking system with cash, increasing the quantity of reserves held by commercial banks. We can say it’s a liquidity game. Such an increase can occur either directly or indirectly.

How is the QE implemented? Let’s say, a central bank buys assets like mortgage securities, government debt from the commercial banks and credit their accounts with reserves by way of payment. Alternatively, a central bank buys assets from non-banks, and these non-banks then deposit the proceeds at commercial banks. This result increase in reserves provides commercial banks with an opportunity to lend more. Basically it is all about increasing liquidity. By increasing liquidity, the aim of QE is to foster an environment of growth by increasing inflation expectations, reducing real rates, and creating asset inflation.

Let’s talk about the risks. Giving the investors incentives to seek higher yields in riskier assets raises the likelihood of creating asset-price bubbles. Inflation is also one of the risks. Investors say that the right before the economy has completely recovered, the Fed shall need to withdraw all the money that it is printing now in order to avoid a surge in inflation down the road. Most investors and economists don’t believe that the Fed will be able to do that quickly enough, and fear inflation will result.

Another problem is the value of the dollar. If I announce today that I found the way to create the gold from any piece of metal, what will happen to the gold price? I think by announcing that, the price of the gold will go down by couple of hundred dollars. With QE it is the same. Printing more money tends to push down the value of the dollar. While this is a help to the U.S. exports, it also risks pushing up the price of oil and other commodities, threatening an inflation surge that could be difficult to stop if the economy picks up. As we discussed at the class, the weak dollar will result the flood of money to emerging markets with higher interest rates and more strong growth is pushing up their currencies more than some of their governments wants. This already has led some countries to intervene to resist the rise in their currencies, sparking tensions between the U.S. and emerging markets and talk of “currency war.”