What is Quantitative Easing?

I’ve been getting asked this question a lot lately, so I thought instead of telling people to immerse themselves in some boring text book, I’ll do my best to explain it in the simplest possible way right here. Although it will still be boring – sorry, there’s no way around that.

Before we talk about quantitative easing, it’s best to understand “open market operations” that a central bank can perform.

Open Market Operations

The yield curve is a graph that shows the yield of debt instruments of different maturities. 90 day t-bills have a certain yield. 6 month notes, 1, 3, 5, 10 and 30 year bonds have their own yields as well. When you plot them (yield on Y, term to maturity on X) you get a yield curve.

Click here to see a sample yield curve.

The “overnight rate” is the yield on the very left hand side of the graph essentially and represents the rate at which banks lend to one another. This is the interest rate everyone talks about when Bernanke (US) or Mark Carney (Canada) makes “an interest rate announcement”. They lower this when they want to stimulate the economy or prevent deflation. They raise it when they want to curb inflation or perhaps encourage saving. For consumers, it normally dictates the cost of borrowing money as the prime rate (the rate banks lend to their best customers) is based on the overnight rate.

When a central bank changes the overnight rate but banks don’t adjust the rate they lend to one another, the central bank engages in open market operations to ensure that they do. For example if the central bank lowered the overnight rate, but the banks didn’t adjust, the central bank would print money* and use it to buy short term treasuries. This buying pressure on treasuries drives their prices up, which means their yields fall and hence the interest rate falls.

*Please note: printing money in this sense is not the same as “monetizing the debt” which means printing money for the sake of paying off debt. The financial press is a bit sloppy about using this term in this context. I included it above so I could make the distinction here.

Quantitative Easing

When stimulus is required to prevent a recession or get out of one, the overnight rate can be lowered until it gets to zero. But if that isn’t enough, and access to credit is either retarded or there is a general lack of “liquidity”, the central bank can engage in quantitative easing. This is also printing money* but it is used to buy debt instruments at different parts of the yield curve, of different maturities. This would decrease interest rates for further out on the yield curve as opposed to only the overnight rate.

So open market operations are dealing primarily with very short term debt, and quantitative easing is dealing with longer term debt once the overnight rate is zero. That’s it.

I’ll point out that the buying of longer term debt securities is somewhat indiscriminate.

*Again – not the same as monetizing the debt.

Credit Easing

“Credit Easing” is targeted quantitative easing in a sense. If quantitative easing is successful in reducing the overall government debt yield curve or injecting money into the system, but there is no trickle down effect to corporate bonds for example, then the central bank can target specific maturities and specific types of debt instruments (corporate bonds OR auto loans, mortgage backed securites, etc.) to achieve the desired effect. If for example, banks were having trouble floating bonds because the spread of corporate bonds was too high versus government bonds (yields were very high because prices are low due to little demand to own these bank issued bonds) they could buy these types of bonds to get money flowing in this space if the central bank so desired.

Told you it was boring.

 

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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Showing 13 comments
  • Canadian Couch Potato

    My god, that was so boring. I fell asleep reading it.

    Having said that, I realize that you are pretty much a god.

    • Preet

      There was a disclaimer – what more can I do?

      • Preet

        By the way (anyone who is sick enough to have read this and then gone one step further to read the comments), I edited Canadian Couch Potato’s comment to add that second line. His first line was all that was on the original comment.

        I’m a wild one.

      • Canadian Couch Potato

        I should sue you for sullying my professional reputation. Editing comments? You’re way over the line, pal.

      • Preet

        Did you mean to say, “You should sue me for taking up your bandwidth and wasting everyone’s time.”?

        Because I can make that happen in less than one of your earth minutes.

  • Canadian Couch Potato

    You’re a funny guy. A funny gut who wrote a post called “The Grossman-Stiglitz Paradox.”

    • Preet

      You’re being passive aggressive.

  • dj

    Poor CCP…his investment plan is not doing to well

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