Quantitative Easing has been a buzzword in the financial markets for the past few years but what does it really mean? Lets start by breaking down the 2 words:
Quantitative = Refers to a Specific Amount
Easing = Refers to Providing Easier or Looser Lending Conditions for Banks
Quantitative Easing is a form of monetary policy that central banks use to stimulate their economy when interest rates are zero. The goal is to increase the supply of money and to get banks to lend which will hopefully start a virtuous cycle of investment and consumption.
Where does the money come from?
Contrary to popular belief, central banks do not fire up their printing presses. Instead, they simply turn on their computers and add a few zeros to the end of their bank accounts and magically money is created.
The central bank then uses the money to buy government bonds and other assets from Bank A, B and C. In the case of the Federal Reserve, they almost always buy longer term bonds or mortgage backed securities because short term yields canâ€™t go any lower. Buying short term bonds wonâ€™t achieve any material results while purchases of 10 or 30 year bonds would lower long term interest rates, providing direct support for consumers and business whose loans are generally tied to longer term rates.
The central bank also puts the newly created money into the hands of Banks A, B and C with the hope that they will lend to consumers and businesses. There are no guarantees of course because the banks are in no obligation to lend. If banks are nervous about the economic outlook, they may opt instead to save for a rainy day by putting the money from the Federal Reserve under their own mattresses.
How Does Quantitative Easing Impact the Markets?
Aside from driving bond prices higher and yields lower, Quantitative Easing tends to be good for stocks but bad for the countryâ€™s currency. Since Quantitative Easing involves printing money to buy a variety of securities with the end goal of flooding the financial markets with cash or liquidity, the amount of currency in circulation reduces the value of the currency and boosts inflation.
One way to look at this is to imagine that if there were only 100 signed Babe Ruth baseball cards worth $1000 each in the world and all of a sudden another 1000 signed baseball cards were discovered, then you would expect each baseball card to now be worth less. Having more baseball cards in the market at lower prices hopefully spurs more activity in the baseball card market. In many ways, the goal of Quantitative Easing is the same. By the flooding the market with liquidity, the central bank aims to promote lending and prevent a shortage in the future.
The following chart shows how the S&P 500, EUR/USD, USD/JPY responded to the beginning and end of the first two rounds of Quantitative easing (yellow line = SPX, white line = EURUSD, orange line = 10 year yield). In both cases, stocks and currencies appreciated significantly once QE began and sold off at the tail of Quantitative Easing.
Impact of QE1 and QE2 on the Markets