QE

Tomorrow Ben Bernanke will be speaking at Jackson Hole. In 2010, at Jackson Hole, Federal Reserve Chairman, Ben Bernanke, announced QEII. Many pundits are speculating whether QEIII will be announced tomorrow at Jackson Hole. But many people do not even know what QEII or QEIII (quantitative easing is). Here’s the 101 on ‘quantitative easing’ (QE), a term much in the news lately in the context of economic growth concerns both within the U.S. and without.

QE is basically a tool used by the monetary authorities and central banks in unexpected and extreme situations when a country’s economy does not respond to the standard monetary measures that work in a normally functioning economy.

QE may be required in the event of an event such as the 2008 financial crisis that grew out of the housing market implosion, in the U.S. In U.K. and Europe it is being used to bolster economies reeling under a recession or the debt crisis. QE is often a means of last resort as there may be a situation when existing interest rates are already extremely low yet the economy is not showing signs of recovery. The focus then shifts to increasing money supply rather than reducing interest rates in such extreme situations.

The way it works is as follow; the Government steps in to buy financial assets on a much larger scale than in standard money-market operations, using ‘fiat’ or electronic money for their payment. This money supply chasing those assets causes their prices to reflate, thereby reducing the ‘yield’ or return on those assets. This lowering of yields causes an overall environment of cheaper money and lower interest rates that help the business sector to better run their operations. Cheaper money helps over-leveraged consumer-borrowers to refinance their loans at cheaper rates thereby generating monthly cash savings that help increase consumer spending, which boosts the US economy.

Central banks may also use QE to lower the more long-term interest rate structure in the economy by a process of using the QE funds to buy longer-term assets thereby having the same effect but across a longer time frame.

In the U.S., the economy has already seen QE in two doses, named QE1 and QE2 respectively.

QE1 refers to the first measures taken when the financial crisis broke in 2008. The U.S. government’s holdings of treasury notes, mortgage-backed securities and bank debt rose from about $800 billion in 2008 to $2.1 trillion in August 2010, at which time QE1 was suspended.

A second around of easing, dubbed QE2, was announced in November 2010 and involved the buying of $600 billion in treasury securities up to second quarter 2011.

The Fed recently raised the possibility of QE3, when minutes of its meeting held on July 31 – Aug 1were released. According to the minutes, “Many members judged that additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery. Several members noted the benefits of accumulating further information that could help clarify the contours of the outlook for economic activity and inflation as well as the need for further policy action.”

“Many participants expected that such a program could provide additional support for the economic recovery both by putting downward pressure on longer-term interest rates and by contributing to easier financial conditions more broadly,” the minutes indicate. “In addition, some participants noted that a new program might boost business and consumer confidence and reinforce the Committee’s commitment to making sustained progress toward its mandated objectives.”

A final decision on the matter is expected to be taken at the Fed’s September meeting, however, we could be in for a surprise tomorrow from Ben Bernanke’s speech at Jackson hole.

It should be noted that an immediate impact of the likelihood of QE3 was to cause a weakening of the dollar and an increase in the price of bullion, oil and other risk assets across the globe. With food prices soaring due to the drought and oil increasing over fear of a war between Israel and Iran, no one knows whether QEIII will be announced tomorrow or in September.