Quantitative easing is (loosely) when the government “prints money” and uses it to buy back government debt.
This has the effect of increasing money supply. With more money moving through the economy and less risk free govenment securities, institutions should be tempted to invest in riskier assets thereby lowering interest rates in the market and stimulating the economy.
This would also have an effect on inflation as there is more money chasing the same level of goods and services (or something like that).
Wouldn’t higher inflation lead to higher nominal interest rates? Or is it only real interest rates the central banks are concerned about?
It’s not the government printing money to buy back government bonds; in a system with independent central banks, like the U.S. Fed, it is the central bank which prints money (or, to avoid a term that could be taken too literally, creates new money by crediting it to the accounts commercial banks hold at the central bank). The central bank uses this newly created money to buy securities such as governmend bonds from commercial banks.
This increases money supply; because of the money creation multiplier (the commercial banks get the money in the form of reserves they hold with the central bank, but they are required to hold only a specified percentage of their liabilities as central bank reserves), total money supply - including deposits with commercial banks - rise by a much higher amount.
What makes you think quantitative easing raises nominal interest rate? Investor expectations which demand higher interest rates from borrowers to compensate for losses in purchasing power? That would be the case after the end of quantitative easing, but as long as it continues the constant expansion of central bank money, and the expansion of commercial bank lending permitted by this, will counteract and keep money easily available, at low rates, to borrowers.
Effects of quantitative easing:
Worked like a charm in Zimbabwe, didn’t work in the US so lets do it again, but bigger.
The Wall Street Journal:
“In essence, the Fed now will print money to buy as much as $900 billion in U.S. government bonds through June – an amount roughly equal to the government’s total projected borrowing needs over that period.”
The Fed will in effect fund the debt requirement of the US government almost single-handedly from now until next June. And what with? With money it has created from thin air.
So is this a way of actually financing the national debt? If the US buys back a trillion dollars of debt this way is that debt erased? Is there any way I could do the same with, say, my mortgage?
No, the U.S. is not buying back the debt. At a first stage, the bonds are sold to private investors - usually commercial banks. At a second step, the bonds are sold by these banks to the Federal Reserve System, which pays for them by creating new money which they credit to the accounts which the commercial banks hold with the Fed. The government debt is not erased, it is now owed to the Federal Reserve. The commercial banks use the newly acquired credit with the Federal Reserve to expand their lending (which is what the Fed intends with these measures), and partially also to buy new government bonds from the Treasury. The inflationary risk, however, is there, since money supply increases.
One effect, according to this Daily Finance article, is that the cost of “consumer essentials” is going way up:
Why would consumer essentials go way up? The only link I can think of is that, since our economy is global, the QE2 weakening of the dollar would cause the price of basic commodities to rise. Or is the rise in these prices happening anyway and unrelated to the Fed’s latest move?
I thought it would raise nominal interest rates through inflationary expectations.
Lenders anticipate inflation and so add a premium to their rates (thinking long term).
Is this not a resonable thing to think. (not being facetious, not an economist).
PS: I know about the role of the reserve bank and fractional reserve lending but didn’t fell like going into that much detail in the OP.
EDIT: I am guilty of posting before I fully read your response. I see you already covered this.
Honestly, I’m an economics novice. However, if I understand it correctly, it’s fundamental monetary policy – see: Quantity theory of money. And I’m certainly not qualified to comment on correlation vs. causation.
As with all things economic (seemingly, anyway), the real world is not only more complicated than that, but I have little doubt that the theory is also contested by some. I’d be happy if someone would provide more detail or correction.
Hijack: My mom called me up this morning to ask me why CNBC kept talking about QE2. (She and my father have CNBC on all day long.) At first, I assumed that they must be talking about Elizabeth II or RMS Queen Elizabeth 2 but after a web search, I figured out it was a media phrase for this thing (quantitative easing, the second effort).
Commodity prices are not going up because of the Fed’s actions, but for other independent reasons. Among those reasons are the fact that countries like China and India are working very hard to build up a middle class. Those people want stuff (food, clothes, roads, cars, houses, etc.), and commodities are the raw materials that stuff gets made from.
Sometimes you can blame particular causes for commodity price increases - like corn’s increased demand resulting from the higher ethanol requirements in gas - and other times, it’s just general demand rising.
Higher inflation is certainly one outcome of quantitative easing… but the recession is already putting very strong deflationary pressures on the economy. Thus, the experts think that they can get the benefits without the penalties. I’ll take their word for it, but not with a great degree of confidence.
There are already two threads on this topic in GD forum. I’d make three comments, but am not an expert so consider them questions instead.
(1) Neither liquidity nor interest rates is a big problem now; thus the F.R.B. action is taken not because it’s the best kind of stimulus for our problems, but because it’s the only major stimulus available without Congressional authorization.
(2) Many textbook solutions for closed economies don’t work in the global economy because funds and commodities cross borders so easily. (An example of the kind of mistake I mean is U.S. inflation-fighting measures when oil prices rise. 
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(3) Because of (2), the F.R.B. stimulus is not having the desired effect. Investors are putting the “new” money to work in booming Asian economies, rather than in the stagnant U.S. economy.
If I understand responses in the other threads, I’m missing the purpose of the “stimulus” which is instead primarily just to drive down the value of the dollar relative to other currencies (though of course U.S. officials would be loathe to state this explicitly).
Comments?
Your logic is perfectly legitimate, and it lies at the heart of Hayek’s explanation of business cycles. What you have here is the conflict between long-term and short-term effects of policies. In the short run, monetary expansion - either through lower interest rates, or through direct liquidity injection by means of quantitative easing - will lower interest rates because money becomes easily available. In the long run, however, inflation rates will rise, and so will investor expectations. We’re currently having the same debate in Europe, where the European Central Bank (for which I had the pleasure to be an intern this summer and fall) purchased, and is still purchasing, government bonds at a large scale - even though there it is not so much intended to expand the money supply, but to keep the bonds of financially troubled EU member states floating, which would have trouble issuing bonds at affordable rates without such measures.
You might also be interested to read about the Phillips curve, the theory (developed in the 1950s) that you can “buy” high production and low unemployment rates by putting up with high inflation. The present-day consensus on this theory is that it works in the short run at best, since over a longer period investor expectations accustomed to the high inflation rates will adjust accordingly and offset the production-enhancing initial effects.
The rate of interest is the price of money. If there is more money than needed in the economy, short term interest rates drop. It’s supply and demand.
The problem comes with the expectation of inflation. Investors at the long end of the yield curve (15-30 year maturities) will demand a premium to cover the anticipated rate of inflation. Investors at the short end will be influenced in a similar fashion but since the fed’s QE2 action is targeting 2-10 year maturities (almost all of the $600 billion will be spent in this range), that will probably be the dominant effect and cause rates for those maturities to decline.
There is already over $1 trillion in excess reserves and this money is not being used at all. You can see that from the money multiplier which has been under 1 since July of 2009. The theoretical value is the inverse of banks’ reserve requirement. That is normally around 10% so the theoretical multiplier would be 10. But historically it tends to be in the 2-3 range.
The new round of QE is, in my humble opinion, more a public relations move to drive down the value of the dollar making domestically produced goods more attractive to foreign buyers. But since many commodities are denominated in dollars, the effect is to increase the dollar cost of those commodities.
So (ignoring QE’s effect on interest rates), you’re saying that it’s a move to affect the prices of imports/exports? If I understand dauerbach’s questions, that answers his first question affirmatively. But it leaves the second unanswered:
There is always a certain degree of inflation, and this is actually desired. Most modern central banks have an inflation target, in the sense that their mandate requires them to base their policy on a particular inflation rate which is deemed desirable (this does not go without saying - in the past, for instance, the Fed used to base its policy on a target for the interest rates banks charge for overnight loans to each other). This inflation target in modern Western economies is low, but positive - the ECB’s target is 2 %, and not more but not significantly less either. I don’t know about the Fed’s target (IIRC it is less specific than the ECB’s), but there are certain economic grounds for a “low, but positive” inflation rate. This means that annual price increases of this scale are considered healthy and desirable.
So inflation is out there, it happens all the time, and prices keep rising continuously (on average - some products get cheaper over time, but consumer price indexes measure averages) without us having to worry about it. What makes the Fed’s envisaged QE controversial is the fear that it will hike inflation rates beyond the acceptable level.
I don’t trade commodities, but as I understand it there are several factors involved in their price being bid up. One factor is the value of the dollar. Currently, the dollar index (the dollar compared to a basket of other currencies) is a little under 77. That’s quite low historically with the all time low being around 72 IIRC. At the end of 2009, it was around 75 but mid year with the Euro crisis reached almost 90. As recently as mid-August it was almost 84 - so it’s come down by nearly 10% in just 10 weeks roughly. That will certainly affect commodities denominated in dollars.
But aside from that, I personally believe there is excessive speculation in the commodity markets. Just look at oil hitting $140 a barrel a couple of years ago for no good reason other than rampant speculation. Or look at the pre-crash valuations of stocks like Potash or Freeport-McMoRan. Whenever there are fears about the value of fiat currencies, people pile into what are perceived as “safe” trades like commodities. The idea is that if fiat currencies lose their value, the value of what they are used to buy will have to increase to compensate. The problem is that it becomes a self-fulling prophecy.
That’s not just Hayek. Milton Friedman himself pointed out that extended periods of low interest rates were a sign of tight money.
If money weren’t so tight, long term rates would rise from expectations of inflation. But that’s another way of saying that rates would rise from expectations of economic recovery.
The Fed doesn’t have an explicit target. Before the great financial clusterfuck of 2008, they acted with an apparent implicit target of around 2%. That core inflation has dipped to 1%, and was giving every indication of continuing downward, is a key reason why they’re instituting another round of purchases.
I’d give my left lung if they’d state an explicit target of a long term nominal income path. I’d give at least a pinkie for an explicit price level path.
That is interesting. I knew the Fed had a dual mandate - price stability and economic growth/employment, none of which is subordinate to the other (unlike the ECB, where the economic policy mandate may only be pursued to the extent this is compatible with the price stability mandate), but so far I was under the impression that the price stability aspect was quantitatively defined.
Keep an eye on the ECB and the Euro. My personal opinion is that the ECB is going to monetize the bad debt of the PIGS (Portugal, Ireland, Greece and Spain). Apparently Ireland will run out of cash in the next couple of months. Since there is no consensus for any kind of unified govt response, the only way to prevent a default will be for the ECB to buy Irish debt and recapitalize their banks. That is going to tank the Euro.
Again, this is just my semi-quasi-informed opinion.