Current Events #2Dr. Jon Scott | Financial Markets and Institutions for BusinessKevin Vo & Ron Martin

Has the implementation of Quantitative Easing 1, 2, and 3 had the desired effects on the U.S. economy?

Many central banks across the world, including the U.S. Federal Reserve, have a pivotal

role on managing and sustaining the health of the global economy, especially on economic

recovery from recessions. When the recession occurred in 2008, the central banks stepped in to

jumpstart the global economy by implementing numerous monetary policies, most notably

quantitative easing. Quantitative easing is the process when a central bank buys a large amount

of securities from commercial banks and other financial institutions to boost the money supply,

thus lowering the fed funds rate to stimulate lending and liquidity. In this case, the Federal

Reserve took on three rounds of quantitative easing in separate occasions: QE1, QE2, and QE3.

Each of these phases occurred when the central bank purchased a large sum of Treasury and

mortgaged-backed securities, accumulating over $4 trillion.1 The process of quantitative easing

can create a major impact on world economies, as well as the structures and operations of major

banks and financial institutions. In this case, QE1, QE2, and QE3 have yielded mixed results to

achieve the desired effects for the U.S. economy.

The first round of quantitative easing, or QE1, occurred in late November 2008 when the

Federal Reserve began purchasing $600 billion in mortgage-backed securities in response to the

subprime mortgage crisis. The process of QE1 lasted for almost two years, as the Federal

Reserve halted the process of quantitative easing in June 2010, accumulating to a total amount of

$2.1 trillion in debt securities on its balance sheet.2 Even though QE1 succeeded in stopping the

recession, it did not achieve much success on stimulating economic growth, as banks became

less likely to lend with lower rates. In response, the Federal Reserve began taking on QE2, the

second round of quantitative easing when the central bank purchased an additional $600 billion

of Treasury securities, spanning from November 2010 to June 2011.3 QE2 was implemented to

increase demand for borrowing to increase inflation and more importantly, to lower short-term

Treasury yields.4 And lastly, the Federal Reserve took on the final round of quantitative easing,

or QE3, at the start of September 2012. The initiative would enable the Federal Reserve to

purchase $40 billion worth of mortgage-backed securities per month, alleviating banks and

financial institutions from holding more toxic assets, usually consisting of subprime mortgages.5

So far, the process of quantitative easing has provided some beneficial effects such as increased

economic growth and liquidity in the U.S. However, there are still many drawbacks persisting

from the results of quantitative easing.

Even though the purpose of quantitative easing was to provide monetary accessibility and

liquidity to the public, most of the cash from the Federal Reserve is held in excess reserves by

major banks and financial institutions. When quantitative easing is applied, the process of

purchasing debt securities by the central bank caused the fed funds rates to be lowered

to approximately 0%, interest rates at which depository institutions would lend reserves to other

banks at a certain amount overnight. With the fed funds rate currently fluctuating between 25 to

50 basis points (e.g. .5% = 50 basis points), the interest on excess reserves (IOER) still remained

at a higher rate of 50 basis points. Therefore, banks are more likely to hold cash in excess

reserves as they would earn more with the IOER than the rate from lending reserves. In other

words, quantitative easing provides an arbitrage for banks to earn a higher interest on excess

reserves, since the IOER is considered risk-free and more profitable than conventional lending,

which carries a certain level of risk.

As of November 2016, the Federal Reserve currently holds $4.41 trillion of total assets,

with a vast majority of holdings that consist of U.S. Treasuries and mortgage-backed securities.6

QE1, QE2, and QE3 not only affected the Federal Reserve’s balance sheet with more assets and

liabilities, but many banks experienced the impacts as well. The balance sheets of private banks

did not experience inflated numbers compared to the Federal Reserve’s, but instead, a

composition change from the amount of security holdings shifting to reserves on the assets side.7

When the Federal Reserve purchased mortgage-backed securities in QE1, it was implemented to

save the commercial banks and other depository institutions from incurring further asset losses

and risks of long-term bank failures.8 QE1, in addition with the Federal Reserve’s purchase of

U.S. Treasuries from QE2 and QE3, have motivated banks to increase excess reserves, the

amount of holdings to absorb sudden losses from loan defaults, cash withdrawals, or any

macroeconomic circumstances. However, the objective of banks holding more excess reserves

does not always provide benefits for the U.S. economy as a whole. Despite the spread between

the fed funds rate and the IOER, the amount of cash in excess reserves cannot be lent out to the

public as ordinary loans, since lending only applies to depository institutions. The process of

quantitative easing does not directly provide monetary accessibility for the public to spend and

lend, since the transaction of the Federal Reserve purchasing securities is only directed toward

commercial banks and financial institutions.

Nevertheless, quantitative easing is more than just achieving efforts to increase the

money supply or prevent bank failures; it is also aimed to influence long-term government bond

yields by lowering short-term rates in the yield curve. To understand the concept of the yield

curve, it is a line chart that reflects the relationship between interest rates and the maturity of

government securities. In this case, the Federal Reserve can only control short-term rates by

buying or selling securities when it seeks to target long-term rates at a certain level. During the

phase of QE2 and QE3, the yield curve becomes flattened as the Federal Reserve continues to

purchase debt securities, thus pushing down short-term rates near 0%.9 The shape of a flattening

yield curve does not always predict the future of the U.S. economy, even when the process of

quantitative easing still persists. As a result of the flattening yield curve, this caused a higher

demand for long-term bonds, resulting in lower long-term yields. Lower yields would enable

more borrowers like new homeowners with mortgage loans or startups with long-term debt to at

affordable rates. As lending continues to increase based on current economic and banking

situations, more economic growth in the U.S. could accelerate in the long-run.

Inflation is an important economic factor that can be impacted as a result of quantitative

easing. It was believed that quantitative easing would lead to hyperinflation for the U.S.

economy; nevertheless, this did not occur as the economy was already in a deflationary state

after the recession.10 Before QE2 took place, the inflation rate was 1.1% as of November 2010,

which was below the standard rate of 2%.11 A low inflation rate, or deflation, can signify slower

economic growth, due to the anticipation of high unemployment and falling prices as consumers

would delay purchases and spending, thus causing prices to fall precipitously.3 The

implementation of QE2 and QE3 was designed to break the cycle of deflation; therefore, the

purpose of increasing the money supply would cause the inflation rate to rise, increasing prices

to drive employment and consumer spending. So far, the current inflation rate for the U.S. is at

1.6% through 12 months ending October 2016.13 Even though the current inflation rate is still

short from reaching 2%, the rate is still expected to rise as the economy continues to grow.

  At this point in time, we believe that the current phase of quantitative easing will be able

to achieve more for the desired effects of the U.S. economy in the near future. Overall, the

process of QE1, QE2, and QE3 did manage to achieve its goal on jumpstarting the U.S. economy

from the effects of the recession. QE1 alleviated banks and financial institutions from holding

mortgage-backed securities during the subprime mortgage crisis in 2008. However, it did not

accomplish the specific task of spurring high economic growth as banks continued to accumulate

more excess reserves instead of lending with other depository institutions. The implementation

of QE2 and QE3, in response to the insufficiencies of QE1, have accomplished more to spur

economic growth by combating deflation and influencing the yield curve. As of now, it is still

too early to determine whether if the three quantitative easing measures have fully succeeded in

sustaining the U.S. economy for the long-run.

SOURCES

1) http://www.nytimes.com/2014/10/30/upshot/quantitative-easing-is-about-to-end-heres-what- it-did-in-seven-charts.html?_r=0

2) https://www.thebalance.com/what-is-qe1-3305530 3) https://www.thebalance.com/qe2-quantitative-easing-2-3305531 4) http://www.businessinsider.com/a-close-look-at-treasury-yields-and-qe2-2010-11 5) https://www.thebalance.com/what-is-qe3-pros-and-cons-3305533 6) https://www.federalreserve.gov/releases/h41/Current/ 7) http://www.cnbc.com/id/100760150 8) https://www.creditwritedowns.com/2011/06/qe1-versus-qe2-versus-q3.html 9) http://marketrealist.com/2014/03/fed-taper-quantitative-easing-affects-yield-curve/ 10) http://www.investopedia.com/articles/investing/022615/why-didnt-quantitative-easing-lead-

hyperinflation.asp11) http://www.forbes.com/sites/petercohan/2011/06/22/was-600-billion-qe2-a-waste-of-

money/#75615133442012) http://www.usinflationcalculator.com/inflation/current-inflation-rates/