What is Quantitative Easing?

With the Fed rate at 0%, the Board has used up all traditional Monetary policy.  With a heavy GOP majority in the house, it is unlikely that any Fiscal policy will b e implemented in the next 2 years.   This scenario has left chairman Bernanke with an unorthodox move called Quantitative Easing or QE.  In the fall, the Fed announced a new round of QE (called QE2),  click here for CNN/Money coverage.

So what is this?  It’s actually not terribly difficult to see the reasoning with some basic supply and demand.

  1. The Fed buys back federal bonds
  2. Bond supply goes down, therefore price goes up
  3. Bonds have the inverse relationship.  As price goes up, market or effective yield goes down.
  4. The lower the yield, the more incentive there is for investors to move in stocks rather than bonds.

Support/Criticism for this plan seems to fall on party lines (no surprise but seriously it shouldn’t).  Most of us really don’t have any knowledge about these things to have an intelligent opinion nah or yeah.  However, the notion that the Fed has gone outside their power with QE’s is ridiculous.

The Fed controls interests rates by buying and selling short term bonds.  This method is how the FED controls the money supply and as a result, controls the interest rates.  The only difference between normal Fed control and QE is that the current interest rate is 0%.  We are at a liquidity trap so the normal policies can not lower the interest rates.  QE differs by not targeting a lower interest rate but to instill investment in the economy.  Some have called this printing money but this is not true.  No cash is added into the economy.

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