Understanding the Federal Reserve, Part Seven: QE and QT

David Frost // Better Investing, Blog


March 12  

This is part seven of a series on the Federal Reserve about quantitative easing (QE) and quantitative tightening (QT). Click here for part one. Click here for part two on the history. Click here for part three on the Fed’s structure. Click here for part four on interest rates. Click here for part five on open market operations. Click here for part six on monetary policy tools.

Two terms you might hear talked about in relation to the Federal Reserve are “quantitative easing” and “quantitative tightening,” which are sometimes shortened to “QE” and “QT.” Quantitative easing is an expansionary monetary policy, while quantitative tightening is contractionary.

What is quantitative easing and why is it done?

When the Fed begins a new round of QE, it means that the central bank is purchasing securities from the market with the goal of boosting the amount of money that’s available in the financial system. The other goal of such a move is to encourage investment and lending. 

Quantitative easing differs from standard open market operations in that it starts to work when regular open market operations are no longer effective. In particular, the Fed may begin a round of QE when interest rates are already close to zero, but the economy just isn’t growing. QE is also used when inflation is very low or running in the negative.

The Fed used quantitative easing during the recovery after the 2008 financial crisis. Central banks in other countries were using it even before the financial crisis. QE is designed to bring the economy out of a recession, although there has been controversy over whether or not it actually works as intended.

In some ways, quantitative easing can straddle the line between fiscal and monetary policy because it often involves the purchase of long-term government bonds. These bonds are issued to support government spending when it’s running at a deficit. QE can also involve the purchase of corporate bonds or other securities, while standard open market operations focus more on government securities.

How does QE work?

When interest rates are close to zero and inflation is either close to zero or negative, the Federal Reserve may decide to implement a round of quantitative easing by purchasing a set number of government bonds and other credit assets. This injects liquidity into the economy. The central bank decides ahead of time how much to buy. 

QE can involve buying riskier assets or securities with longer maturity dates than what are usually involved in standard open market operations. The Fed doesn’t even take into consideration interest rates when buying the set number of bonds or other credit assets from the financial markets.

By pulling the levers of quantitative easing, the Federal Reserve impacts the nation’s economy in a few different ways. The most obvious effect is in the credit market, where the central bank injects money by purchasing securities. Additionally, by purchasing securities that are riskier than government bonds, the Fed lowers the interest yield and raises the prices on riskier credit assets.

When the economy is in a recession, investors typically seek out safe-haven investments such as government bonds. However, by purchasing more government bonds during a round of QE, the Fed makes fewer safe assets available, pushing investors to look to assets which carry slightly more risk in search of yield. Investors then must rebalance their portfolios to include other assets.

By increasing the amount of available money in the financial system, the Fed also lowers exchange rates of the dollar against other currencies. Low interest rates result in capital flowing out of the country, which reduces foreign demand for the dollar. This benefits exporters in the U.S., although devaluing the currency can also have negative effects. 

Enacting quantitative easing measures also has a psychological impact on the markets because they signal that the Fed is willing to take extraordinary measures to boost the economy. 

Risks of and controversy over quantitative easing

Implementing QE can be risky, which is why it is deemed a last resort when it comes to jumpstarting the economy. There has also been debate about how much it actually helps the economy recover. 

A key risk of quantitative easing is that it could cause inflation to run out of control. Thus, the Fed must be careful not to overestimate how much easing is needed. If too much money is injected into the financial system, inflation can get out of control and cause the recession to worsen.

Another risk is that QE might fail to jumpstart the economy. It only works if banks are willing to loan money to consumers and businesses. If they aren’t willing, then the market becomes stagnant, and the money that’s been injected never filters down to the rest of the economy. 

Many have debated about whether quantitative easing actually works. During the global financial crisis, the Fed injected $4 trillion into the nation’s money supply. However, banks kept $2.7 trillion in extra reserves, signaling that they weren’t very willing to pass that money on to consumers and businesses.  

What is quantitative tightening?

As the opposite of QE, quantitative tightening is designed to decrease the amount of money that’s available in the economy. The point of QT is to normalize interest rates by raising them from zero, near zero or even negative. After quantitative easing has successfully jumpstarted the economy and inflation starts to take off, QT is needed to keep inflation from continuing to increase. 

Quantitative tightening makes it more expensive to borrow money, thus reducing demand for goods and services. The process also involves reducing the size of the Federal Reserve’s balance sheet by selling off some of the assets or securities that were purchased during the QE phase.

How does QT work?

When the Fed switches from QE to QT mode, it starts by raising its target federal funds rate. For example, in December 2015 when the FOMC wanted to start normalizing interest rates after the global financial crisis, it raised the target range from between 0% and 0.25% to between 0.25% to 0.5%. Gradually, the FOMC began to bump up the target range until it reached 2.25% to 2.5% at the end of 2018. 

After raising the target for the federal funds rate a few times, the Federal Reserve starts to reduce its balance sheet. As Treasuries reach their maturity date, the government pays them off. During quantitative easing, the Fed replaces maturing securities to keep its balance sheet stable. However, during quantitative tightening, the central bank stops replacing those securities and allows the amount of assets it holds to decline.

The decline in assets on the Fed’s balance sheet must happen gradually, so the amount of assets that were not replaced was capped to start. The central bank increases the caps until it reaches $30 billion a month for Treasuries and $20 billion per month for agency debt and mortgage-backed securities.

About the Author

David Frost