Aug 27

Overview of the Fed and Quantitative Easing

Federal Reserve Chairman Ben Bernanke seems close to having the central bank engage in “Quantitative Easing.” A lot of people may wonder what in the world that means.  Normally I post things more opinionated, but I thought this would be a good tutorial. For the benefit of everyone, I’m going to discuss what bonds are and the role of the Federal Reserve before getting to quantitative easing, or QE, as it’s called.

What Are Bonds?

If you buy a US Treasury Bond the government is promising to pay you a fixed amount over a period of time, which can range from weeks to decades. Let’s imagine you bought a 30-year bond for $100 that pays at 5%. This means you will get $5 per year from the government for 30 years. (There are bonds that protect against inflation but that gets more complicated). You have loaned the government money and they are paying you interest.

What’s different about a bond from a normal loan is that the price of the bond can change, but your interest payment stays the same, in this case $5. The price of a bond is determined by supply and demand.  Say a lot of people wants to invest their money in bonds, so the demand increases.  You can sell your bond on the open market at say $120 instead of the original price $100.  But if I buy your bond, I still only get $5 per year, even though I had to pay more.  This means the rate of return on the bond (called the yield) will be about 4.17%   The price of the bond has gone up and the interest rate (yield) has gone down.  Likewise, if the price of a bond goes up, the interest rate (yield) goes down.  They are always in an opposite relationship.

Interest Rates

One major role of the Federal Reserve System (called the Fed for short) is to set interest rates on government bonds.  If interest rates on government bonds are really high, then people will rather keep their money in bonds than investing in the economy.  This may be good for individual portfolios, but it can slow down the economy.  So the Fed may reduce interest rates to give an incentive for businesses to invest that money rather than let it accumulate interest.  Likewise, if the economy is really booming and there are concerns about inflation (prices increasing), then the Fed may increase interest rates to give an incentive to buy bonds instead of investing money.

Quantitative Easing

At a basic level, the Fed controls the amount of money that circulates in the US economy. It does this through what are called Open Market Operations where it either buys or sells government bonds.  The Fed often does this, but Quantitative Easing (called QE for short) is when it is done on a larger scale in a major economic downturn.  For example, during QE the Fed is more likely to buy long-term bonds, while it usually only buys short-term ones.

What is most important is that during QE the Fed buys a huge number of government bonds from the public.  Banks own a huge amount of bonds, so after QE banks will now have money they can use instead of it being stored in a bond.  When the Fed buys a lots of bonds, the increased demand leads to an increased bond price, meaning interest rates (yields) decrease.  However, right now because of the poor state of the economy the Fed has already cut rates to close to 0%.  So by buying lots of bonds the Fed is not seeking to lower interest rates.  Rather it is effectively putting cash into the vaults of banks (it is all done electronically now of course), with the hope that since banks have more money on hand, they will be more willing to give out loans.  Those loans will lead to increased investments by businesses, which will hopefully get the economy going again.   Ideally, when the economy is in better shape the Fed will sell those bonds again, restoring a more normal money supply.

Republicans seem to enjoy trashing the Fed, such as Rick Perry’s somewhat famous accusation of QE being treasonous.

In any case, I hope this is helpful for people.

3 pings

  1. A Basic Macroeconomic Tutorial: IS-LM Part 1 | Political Creativity

    […] will need to understand how bonds work to understand the IS-LM model.  For a quick overview see my previous post on bonds and quantitative […]

  2. A Basic Macroeconomic Tutorial: IS-LM Part 2 | Political Creativity

    […] market, i.e. the demand for money.  More specifically, it refers to the bond market.  (See my post on the Fed for an overview of how bonds work.)  If the economy is not doing well, there will be low demand […]

  3. View of Republicans as Deficit Hawks Continues to Be False | Political Creativity

    […] August 27, 2012 […]

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