Quantitative Easing 101

Quantitative Easing (QE) are the latest buzz words in the financial markets. It is important to become intimately comfortable with these words because they will be the catch phrase of 2009 thanks to the latest interest rate cuts by the Federal Reserve and the Bank of Japan.

What is Quantitative Easing?

Quantitative Easing is a monetary policy tool that central banks use when they run out of room to cut interest rates. The word “Quantitative” refers to the money supply and easing money supply means to increase it. For many people, this term is new and with good reason because it was only coined by the Bank of Japan in 2001 after they took interest rates to zero. When that happened, they obviously had no more room to cut rates, which made Quantitative Easing their Plan B.

Quantitative Easing basically involves printing money to buy a variety of securities with the end goal of flooding the financial markets with cash or liquidity. By doing so, it increases the amount of currency in circulation which reduces the value of the currency and boosts inflation. A good way to look at this is if there were only 100 signed Babe Ruth baseball cards worth $1000 each in the world and all of a sudden another 1000 signed baseball cards were discovered, then you would expect each baseball card to now be worth a lot less. Having more baseball cards in the market at lower prices hopefully spurs more activity in the baseball card market. In many ways, the goal of Quantitative Easing is the same. By the flooding the market with liquidity, the central bank aims to promote lending and prevent a shortage in the future. Of course Quantitative Easing is much more involved than baseball card trading.

What Outcome Can Be Expected from Quantitative Easing?

Granted that Quantitative Easing has only ever been implemented once in Japan, there is not much precedent. However with that in mind, we are sure that the Fed analyzed the outcome of Japan’s zero interest rate policy before bringing US interest rates within a whisker of Japan’s 2000 levels.

The Bank of Japan embarked upon this new concept in monetary economics in its effort to fight a frustrating period of economic stagnation and decline in 2001 which lasted until 2006. With rates at 0% the central bank was forced to implement some new level of policy to fight the wave of deflation that had plagued the country. Deflation, another renewed catch-word in today’s economic climate, is an overall decline in prices over an extended period of time. We are all familiar with how disastrous an inflationary state can be on an economy, unfortunately deflation is no different. The cause of the phenomenon is when consumers become so resistant to spending that sellers are forced to continuously cut prices. In Japan, the BoJ accomplished their easing targets by expanding the limits as to the types of securities that they would purchase; for instance buying long-term treasuries, asset-backed securities, equities, and new levels of commercial paper. This is all in an effort to flood the financial system with so much excess reserves and liquidity that they would be forced to resume normal lending situations.

In the first year of Quantitative Easing, USD/JPY rose 18.5 percent. This means that the Japanese Yen weakened against the US dollar, which is a textbook reaction to Quantitative Easing. The Nikkei also dropped 28 percent. Between 2002 and the end of 2004, USD/JPY fell 22 percent as the Japanese economy began to stabilize. During that same time the Nikkei recovered 20 percent, but not before it fell another 20 percent. Although it has been heavily debated whether Quantitative Easing drove the turnaround in the economy, most people agree that it put a halt to deflation.

USD/JPY

Nikkei

Fed’s Version of Quantitative Easing

With US interest rates pretty much at zero, the Federal Reserve has informally adopted its own version of Quantitative Easing. Some people may even argue that the Fed has been pursuing this strategy for months now. In conjunction with the Treasury department, the Fed has doubled their balance sheet in the past 3 months to more than $2 trillion. They have done this by purchasing direct equity investments in banks, easing standards on commercial paper purchases, made efforts to relieve institutions of their toxic asset-backed securities and is now considering buying Treasury bonds and agency debt. By buying these assets, they are adding money into the financial system. Like the Yen, Quantitative Easing exposes the US dollar to significant downside risks, but it is also the step that the central bank needs to take to stabilize the US economy and to prevent a deflationary spiral.




EUR/USD: 1,300 PIP TRADING RANGE
GBP/USD: SECOND DAY OF BETTER DATA
USD/CAD: CPI HITS THE UPPER-END OF BoC TOLERABLE INFLATION RANGE
AUD/USD: WEAKER ECONOMIC DATA, LOWER GOLD PRICES
NZD/USD: OIL PRICES AT $33 / BARREL
USD/JPY: BANK OF JAPAN CUTS INTEREST RATES TO 0.1%

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19 Comments

  1. Only for curiosity and analyzing the behavior of the couple EUR/GBP I thought that only in this December(2008) the range in the price is of 1,315 pips (0.8241 – 0.9556) and this range is major that the total range in each one of the years from 1999 to 2007

    In 1999 H= .7169, L= .6192 Range 977 pips
    In 2000 H= .6418, L= .5680 Range 738 pips
    In 2001 H= .6448, L= .5948 Range 500 pips
    In 2002 H= .6549, L= .6072 Range 477 pips
    In 2003 H= .7254, L= .6486 Range 768 pips
    In 2004 H= .7107, L= .6542 Range 656 pips
    In 2005 H= .7092, L= .6608 Range 484 pips
    In 2006 H= .7019, L= .6669 Range 350 pips and
    In 2007 H= .7389, L= .6535 Range 854 pips.

    The month with the lower Range I think is October/1991, with 57 pips, very different that October of this year in that the price was between .8195 (H) and .7693 (L) for 502 pips.

    Regards

    Reply
  2. “In the first year of Quantitative Easing, USD/JPY fell 18.5 percent. This means that the Japanese Yen weakened against the US dollar”

    I don’t understand how the USD/JPY fell 18.5 percent, it looks to me the pair rose 32% (102-135) ?

    Reply
  3. hi Kathy nice post as always!
    one question though:
    in 2001 only japan was doing quantitative easing so it worked for the yen and thus for the japan economy but what happen if the whole planet is doing quantitative easing? well at least the rich nations banks BOJ, ECB, FED and BoE wouldn’t it just help spur inflation without helping much the economy thus creating stagflation?

    Reply
  4. Hi Kathy,

    Are you keeping your view that JPY/YEN bottom is 85?
    In your article, in 2002 to 2004, Japan economy stablized and Nikkei and Yen rose. I recall that Yen interest rate was held at zero till 2006.

    If history repeats itself, that would suggest Dow and USD rising late 2009, early 2010. Wouldn’t it?

    Reply
  5. This post helped me clearly understand what they’re talking about.
    So, now that both the Federal Reserve and the BOJ are practicing a policy of quantitative easing, which currency will the have the upper hand?
    Will the Yen reach an all time high against the dollar? Or will the tables turn?

    Reply
  6. Kathy,
    You talked about the Nikkei falling during the first year of Quantitative Easing. Do you expect to see the see the same for US stock market?

    Reply
  7. Michael > The possibility of stagflation is very real, which is why some economists predict a L shaped recovery. I think we’ll see something more like a U shaped recovery

    Lang and Yohay > I am still looking for more USD/JPY weakness in 2009

    Jordan > Further stock market weakness is very likely in Q1 2009 especially if you believe like I do that Q4 earnings which are due in Q1 will be weak

    Reply
  8. Kathy,
    While I do believe that Q4 earnings will be ugly and we will likely continue to hear more bad news, question is really have all these bad news been baked into the market?

    Reply
  9. I’ve just discovered your excellent site, thank you for explaining QE. I’ve also seen the phrase “Qualitative Easing” and don’t know if it is an accepted, or “made-up” term. Possibly it refers to the Fed purchasing long term Bonds or agency debt, rather than treasuries ? Again, thank for your shared insights.

    Reply
  10. Kathy,

    Fiscal spending means additional issuance of government bonds to finance government projects. Quantitative easing on the other hand means printing money and buying securities, such as government bonds. Is it possible for the government to use both methods simultaneously to stimulate the economy? What would the effect be on the price of government bonds?

    Reply
  11. Good article, but I beg to differ on a couple of few points, as follows.

    3rd para seems to say that the primary objective of Q.E. is to boost inflation. I suggest that the main objective is to get the economy moving, i.e. boost demand and employment. Of course it is likely that inflation will rise a bit in the process, but inflation is not necessarily the object of the exercise.

    If prices were falling at a catastrophic level, then deliberately boosting inflation might be an idea. On the other hand there were periods in slowly falling prices in the UK in the 1800s and before, combined with economic expansion, so having prices fall one or two percent a year is no big problem.

    Also I suggest the whole business of “deflationary spirals” is overdone. Of course falling prices induces households to reduce consumption and wait till prices fall further. But as Keynes pointed out, wages are “sticky downwards”. Put another way many groups of employees (at least in Europe) would refuse point blank to accept hourly wage cuts. This puts a definite limit on the extent to which prices call fall indefinitely.

    5th para claims that the word deflation refers to falling prices. I suggest it has two meanings: 1, falling prices, 2, a decline in, or an insufficiency of aggregate demand. This is more or less the definition in my Penguin Dictionary of Economics, a definition I agree with (I don’t always agree with dictionaries!).

    Reply
  12. I’m confused.

    The whole issue of quantitative easing appears to be nothing other than inflating the money supply as well as manipulating the manner in which finanancial/monetary accounting is presented by the Feds and the Central Banking system . . . all for the sake of putting Humpty Dumpty (the former US economic lifestyle) back together again; the way it was before deleveraging appeared within the global economy.

    Observation and commentaries reflect quantitative easing in Japan did not jubilantly yield the desired outcome. But it could be argued the strategy did work in the manner it was designed . . . resulting in the large economic component of Japanese end users, the masses, continuing their customary frugal way of life . . . being ‘savers’, not spenders.

    Understandably, the anxious, opinionated jury is not even close in accurately determining whether quantitative easing will provide a desirable end result in the US because the strategy is just beginning to being implemented. But the projected outcome could be successful – assuming, of course, the desired outcome is having the abundant supply of newly created monies being efficiently and effectively channeled to the large economic component of American end users, the masses, going back to their habitual lifestyle of spending for immediate gratification and committing to long term debt with a fair number of bankruptcy filings.

    What a huge bet our financial power players are making by implementing such a game plan strategy; for not only is the outcome dependent upon the path of newly printed money, from beginning to end, they (the financial power players) will be hampered to affectively control the end result of implementing quantitative easing due to the inevitable, usually counterproductive wild card being injected along the way by the unmeasureable participation of the political class..

    Quantitative easing also seems as though it could be described as a likely effective, yet unwieldy economic tool that is ‘pushing on a string’ in order to obtain what Kathy Lien appropriately sums up by stating it (quantitative easing) exposes the US dollar to significant downside risks, but it is also the step that the central bank needs to take to stabilize the US economy and to prevent a deflationary spiral.

    Maybe I’m not so confused after all . . . change is inevitable and life IS a gamble.

    Good article – Thanks.

    Reply
  13. Quantitative easing means the central bank handing over new notes to the other banks instead of injecting them into the economy. This does nothing to solve the main problem of banks namely defaulting debtors.

    Reply
  14. Quantitative easing means the central bank handing over to the other banks new notes instead of injecting them into the economy. This does nothing to solve the main problem confronting the banks namely defaulting debtors.

    Reply

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