What it means
Normally, a central bank steers the economy by moving a short-term interest rate. After the 2008 financial crisis, that rate was already close to zero, so the Fed needed another tool.
Buying bonds in large quantities was that tool. When the central bank buys long-term government bonds, it pushes up their prices, and prices and yields move in opposite directions, so yields fall.
Lower long-term yields tend to reduce the cost of mortgages and corporate borrowing. Higher asset prices can also make households and companies feel wealthier and more willing to spend.
The first round, now called QE1, focused on mortgage-related securities and Treasuries in 2008 and 2009. QE2 followed when growth and inflation were judged too weak.
It was announced in November 2010 and intended to buy $600 billion of Treasury securities by the end of the second quarter of 2011, a pace of roughly $75 billion a month. Supporters said the programme reduced the risk of falling prices and helped keep borrowing costs low.
Critics warned that it could fuel inflation, weaken the dollar, inflate asset prices and encourage investors to take excess risk in search of return. Economists continue to debate how large its effects really were.
For finance professionals, QE2 is a case study in how central bank action affects bond yields, exchange rates, equity valuations and commodity prices. Treasurers and investors watch announcements of this kind closely, because the expectation of purchases can move markets before the buying starts.
The eventual unwinding is part of the story. Bonds bought by the central bank sit on its balance sheet until they mature or are sold, and the plan for reducing that holding affects markets years later.
Investors learned from this period that talking about withdrawal can move yields even before any bond is sold.
In practice
Real-world examples.
Example
A corporate treasurer notes that long-term yields fell after the QE2 announcement. She decides to issue a new ten-year bond sooner than planned to take advantage of the lower borrowing cost.
Example
A mortgage lender sees applications rise as rates ease. Its finance team revises the forecast for loan volumes and adjusts its funding plan.
Example
An exporter in another country finds that its currency has strengthened against the dollar. Its CFO reviews hedging arrangements because the weaker dollar reduces the value of overseas sales when converted. She also tracks each central bank announcement in a simple calendar. The CFO also compares the cost of hedging with the size of the exposure before choosing a strategy.
Formula
Calculation
Monthly pace of purchases = total programme size / number of months
Suppose a programme was set at $600 billion to be completed over eight months, from November 2010 to June 2011. The monthly pace is 600 / 8 = $75 billion. If the same $600 billion were spread over twelve months instead, the pace would be 600 / 12 = $50 billion a month, so a longer schedule means gentler monthly buying.Case study
Seen in the real world.
Cobalt Machinery is an illustrative, fictional manufacturer with $80,000,000 of floating-rate debt. When the central bank announced a second round of asset purchases, the CFO considered what it meant for the company's borrowing costs.
She reasoned that long-term yields were likely to fall, so the company could refinance with a fixed-rate bond. A drop of 0.5 percentage points on a $40,000,000 refinancing would save 40,000,000 x 0.005 = $200,000 a year in interest.
The board approved the refinancing and a partial currency hedge in case the dollar weakened. The illustrative lesson is that policy announcements can create borrowing opportunities, but they also change exchange rates and inflation expectations. Over the following year the CFO also tracked the company's hedges, which she reviewed each quarter as the central bank's plans became clearer. She told the board that the refinancing had been sensible but that later changes in policy could reverse some of the market moves. The refinancing closed within a month, and the CFO recorded the interest saving in the next budget so that the board could track whether it was delivered.
Watch out
Common mistakes.
- Thinking quantitative easing means the central bank prints physical banknotes, when it creates electronic reserves to buy bonds.
- Treating it as a cure that works instantly, when the effects build over time and are uncertain.
- Ignoring side effects such as currency moves and higher asset prices.
Questions
People also ask.
What was QE2?
It was the Federal Reserve's second round of large-scale bond purchases, announced in 2010 and worth $600 billion in Treasury securities.
How did it differ from QE1?
QE1 included mortgage-related securities and was a response to the acute crisis, while QE2 targeted Treasuries to support a slow recovery.
Does QE raise inflation?
It can add to price pressures, but the effect depends on demand, bank lending and the state of the economy.
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