Quantitative Easing is an unconventional monetary policy used by the Federal Reserve (FED), to stimulate the economy when standard monetary policy has become ineffective. To better understand how quantitative easing works; let me first detail the more traditional tools of the FED.

The FED uses several tools to control the economy through the supply of money. The FED sets the reserves it requires commercial banks to maintain as a percentage of their depositors holdings. The reserves requirement is usually in the neighborhood of 10% of deposits. When they raise the reserve requirements, the money supply is tightened, and this slows lending. This is used as a tool to slow inflation. When the FED lowers the requirement, this frees money that the banks have to lend, and will stimulate the economy.
The most powerful tool the FED uses to control the economy is known as the FED funds rate, which is the percentage rate on inter-bank lending. The FED sets a target for the inter-bank rate and tries to achieve this target through open market operations, where the FED buys or sells short-term government bonds. When the funds rate goes up, it becomes more expensive for banks to borrow from one another, and is usually done to slow the economy due to inflationary concerns. Likewise, when the funds rate is lowered, it helps to accelerate the economy.

There is also the discount rate, which is the only rate that the FED directly sets. The discount rate is what banks pay when they borrow money directly from the FED. Normally, the FED acts as a lender only as last resort.

Quantitative easing occurs when the FED buys longer term assets like mortgage backed securities from commercial banks, thus injecting money into the economy. This differs from the more usual policy of buying or selling shorter term government securities to change the money supply, as expansionary monetary policy typically involves the FED buying short-term government securities in order to lower short-term rates. However, when short-term interest rates are either at, or close to zero, as they are now, normal monetary policy can no longer lower rates. Thus, quantitative easing is now being used by the FED to stimulate the economy by purchasing assets of longer maturity, and thereby lowering interest rates on mortgages.

Risks of quantitative easing include it being more effective than intended in acting against deflation, and leading to higher inflation, or not being effective at all if banks do not lend their additional reserves. This policy is the last resort for the FED to stimulate the economy. Quantitative easing cannot be implemented forever, and when it stops mortgage rates will rise significantly… so give us a call now to refinance or purchase your home.

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