On Sept 13, the Federal Reserve Board introduced a third round of Quantitative Easing (QE3) in an aggressive move to give the economy the boost needed to create jobs.  The focus is on keeping interest rates low to make it easy for people to spend and businesses to hire.  The Fed will purchase $40 billion of mortgage-backed securities every month until the labor market improves. The Federal Open Market Committee also said it would likely keep the federal funds rate near zero through at least the middle of 2015.

But what is Quantitative Easing and How does it work?

“Quantitative easing (QE) is an unconventional monetary policy used by the central bank to stimulate the national economy when conventional monetary policy has become ineffective.” (1) This is the Federal Reserve using its bag of tricks, lowering interest rates and getting cash to big banks with the hopes that they will lend it out all for the purpose of stimulating the economy.

Ordinarily, a central bank raises or lowers its interest rate target buying or selling short-term government bonds from banks and other financial institutions. When the central bank disburses or collects payment for these bonds, it alters the amount of money in the economy, while simultaneously affecting the price and yield for short-term government bonds. This in turn affects the banks interest rates.

However,when the central bank interest rate is near zero, the central bank cannot lower it further. In such a situation, the central bank may perform quantitative easing by purchasing a pre-determined amount of bonds or other assets from financial institutions.  The goal of this policy is to increase the money supply rather than to decrease the interest rate, which cannot be decreased further. This is often considered a “last resort” to stimulate the economy.

Because the Fed is buying mortgage-backed bonds, the purchases act to directly lower the cost of borrowing to buy a home. In addition, some investors, put off by the rising price of the bonds that the Fed is buying, turn to other assets, like corporate bonds – which, in turn, pushes up corporate bond prices and lowers those yields, making it cheaper for companies to borrow – and spend. If companies use that money to buy equipment and households use it to buy homes and cars etc, the economy gets a boost. So you can clearly see, how QE can trigger a domino effect throughout an economy.

But does it work?

“There have been two (and a half) rounds of QE so far. The first round, starting in late 2008, prevented a Great Depression. As you’ll recall, we didn’t have a Great Depression. In fact, the recession ended in July 2009. It’s pretty clear that Federal Reserve’s extraordinary actions saved the economy…On the other hand, consider the stock market. The Wall Street Journal compiled a great visual showing instances of QE plotted against the Dow. QE should encourage families to take out loans and businesses to expand operations, and we’ve seen the stock market rise with each round of easing.” (2)

The equity market sees QE3 as a positive thing and bids are being raised in the areas that are most likely to benefit like construction, housing and consumer staples.  The downside of this type of measure is the risk of inflation down the road but this is unlikely to be a problem for the foreseeable future and the benefit of QE3 would currently outweigh this risk.  Time will tell but overall, this should be a very positive event in promoting economical activity, consumer confidence, corporate profits and eventually, investment growth.

(1) Wikipedia – Quantitative Easing http://en.wikipedia.org/wiki/Quantitative_easing

(2) The Atlantic magazine http://www.theatlantic.com/business/archive/2012/09/how-does-qe-work-does-it-even-work-at-all/262337/