Econ 101: Quantitative Easing
Explaining the new tool governments use to influence the economy
The Federal Reserve Bank, or Fed, is one of the most powerful agencies of the United States government. The Chair of the Fed, barring the President of the United States, is arguably the most powerful person in the entire country (and is thus also the most powerful person in the US the average American can't name).
Why is the Fed and the leader of the Fed so powerful? Because the Fed is tasked with maintaining the economic stability of the US economy. Given that the US economy produces goods and services worth an unfathomable $23 trillion per year, that is a lot of responsibility.
“Maintaining economic stability” is a broad remit, and the Fed has a lot of tools to influence the economy. Their strongest tool, however, is controlling the money supply. That is, the Fed can change the amount of money circulating in the US economy. And they do. For the last century, the Fed has constantly tinkered with the amount of money that exists for people to buy goods and services.
Why? Because when the amount of money goes up that stimulates the economy. More money means people buy more things. So if the Fed wants to help the economy, it will inject money into the economy. Well fine, you say. But then why doesn’t the Fed always just inject money into the economy? Is this proof that the government is keeping us poor plebeians poor, probably on the advice of the Illuminati?
Not quite. Increasing the amount of money in the economy isn't always a good thing. If there is too much money in the economy, then money won't be as valuable, and prices will rise. In other words, inflation will occur.
So the Fed has a tricky tightrope to balance on. If the economy doesn’t have enough money (or as economists say, a lack of liquidity), it will cause a recession. If the economy has too much, then it will cause inflation. The Fed constantly balances these two concerns. When recessions occur, the Fed will step in and increase the money supply. When inflation is too high, the Fed will decrease the money supply.
The Fed alters the money supply through several mechanisms, the most notable being the buying and selling of government bonds. If the Fed wants to increase the money supply, they buy government bonds and give the bondholders money. If the fed wants to decrease the money supply, they sell government bonds and remove the money they are paid from the economy. These are called open market operations, and it's been part of the Fed’s toolkit for decades.
But what happens if there is a severe recession? One that results in chaos in the markets, mass layoffs, and a possible meltdown of the global financial system? What if the Fed needs to act swiftly and buy massive amounts of securities, not just traditional government bonds but also other securities, to increase the money supply by a massive amount in a short time period?
That is quantitative easing (QE). It's a fancy term for when the Fed buys hundreds of billions of dollars worth of various securities to stimulate the market. What makes it unique is not so much the process, but the scale. The Fed buys and sells bonds all the time, but QE is done at a massive level when the Fed feels it needs to act swiftly and decisively to increase the amount of money in the economy. QE also sometimes involves buying more than just short-term government bonds, such as mortgage backed securities.
To date, the Fed has incorporated four rounds of quantitative easing.
QE1: November 2008
QE2: November 2010
QE3: September 2012
QE4: March 2020
QE1-QE3 were done during the Great Recession. QE4 during the Covid Recession. In each case, the Fed bought hundreds of billions of dollars worth of securities including government bonds and mortgage bonds. The sellers (bondholders) now have billions of dollars worth of money instead of bonds. The goal is that the sellers use that money to buy goods and services, keeping the US economy afloat.
But does it work? So far, the evidence is mixed. Because QE only occurs in times of crisis, and has only been around for several decades, economists have to rely on models to assess the impact. Those models depend heavily on parameters the researcher chooses. The result is that some models say QE is ineffective while others say it's effective. My personal belief is that QE is one tool among many that likely has some effect, but it is not a silver bullet. Either way, QE is now an established part of the Fed’s toolbox, and I expect to see it during the next financial panic.