Quantitative Easing

To make this term more clear to the reader, I would be taking up some questions, and the answers to which will help in understanding the term better.

Very often we hear this term coming up in news papers. But what exactly it means?.

This term has been around in finance news for couple of years since recession kicked in on global markets. It started when central bank of US had no other avenues left to increase the inflation which was touching abyss. Let's first understand how central bank control inflation.

What are the options available to Central bank for controlling Inflation?

In order to control inflation, central bank changes interest rate. If interest rate increases, people want to borrow less, as it becomes costlier for them to borrow from market.

Industries scrape project because, what we typically call in Finance World, "The Net present value of project" becomes negative. As a result of which, supply and demand both decreases, which in turn reduces inflation.

Central bank was trying to boost growth in country. Declining inflation suggested that there was decrease in manufacturing activity happening. Also consumption was low. To tackle this situation, government reduced the interest rate. It helped still demand was not pushing.

As we can see that around 2009, interest rates bottomed to almost zero level.

Now what? Government cannot reduce it any further. It cannot make interest rate negative. No one will keep their money with government in that case.

So, in order to pump liquidity into the system, Fed increased the monetary base. Monetary base is the total amount of money which is rotating in the country. Like if central bank issues a $100 note, and if statuary requirements requires banks to have 10% in bank vaults, the total money in circulation would be 100/0.1=1000. This is called the money multiplier effect.

So government stated pushing money into the system. But how? Can it distribute money like leaflets. The obvious answer is no. So how did they pump more money in the system.

They purchased the CMO's which banks at that time were loaded with. All good for nothing. But that helped banks to manage their debt and bring them back in liquid state.

What  did central bank do with them?

They kept it with the faith that these banks will start walking, without any support, and buy back these CMO's.

Lets look at this phenomenal increase in monetary base with the help of data.

As we can see that around 2009, monetary base started increasing. That is QE1. Government pushed in a hell lot of money in the system. More money that it had pushed in last 50 years. Result was an increase in inflation, which government wanted.

Lets see the impact of QE on inflation by a graph

QE helped in boosting growth and as a result inflation started to increase. Effect of QE on inflation was lagged. And therefore, impact on inflation was seen starting from 2009, but QE stated in around Oct 2008.

With this small article I tried to establish relationship between interest rate, QE and Inflation.