1. Current Events #2
Dr. Jon Scott | Financial Markets and Institutions for Business
Kevin Vo & Ron Martin
Has the implementation of Quantitative Easing 1, 2, and 3 had the desired
effects on the U.S. economy?
Many central banks across the world, including the U.S. Federal Reserve, have a pivotal
role on managing and sustaining the health of the global economy, especially on economic
recovery from recessions. When the recession occurred in 2008, the central banks stepped in to
jumpstart the global economy by implementing numerous monetary policies, most notably
quantitative easing. Quantitative easing is the process when a central bank buys a large amount
of securities from commercial banks and other financial institutions to boost the money supply,
thus lowering the fed funds rate to stimulate lending and liquidity. In this case, the Federal
Reserve took on three rounds of quantitative easing in separate occasions: QE1, QE2, and QE3.
Each of these phases occurred when the central bank purchased a large sum of Treasury and
mortgaged-backed securities, accumulating over $4 trillion.1 The process of quantitative easing
can create a major impact on world economies, as well as the structures and operations of major
banks and financial institutions. In this case, QE1, QE2, and QE3 have yielded mixed results to
achieve the desired effects for the U.S. economy.
The first round of quantitative easing, or QE1, occurred in late November 2008 when the
Federal Reserve began purchasing $600 billion in mortgage-backed securities in response to the
subprime mortgage crisis. The process of QE1 lasted for almost two years, as the Federal
Reserve halted the process of quantitative easing in June 2010, accumulating to a total amount of
$2.1 trillion in debt securities on its balance sheet.2 Even though QE1 succeeded in stopping the
recession, it did not achieve much success on stimulating economic growth, as banks became
2. less likely to lend with lower rates. In response, the Federal Reserve began taking on QE2, the
second round of quantitative easing when the central bank purchased an additional $600 billion
of Treasury securities, spanning from November 2010 to June 2011.3 QE2 was implemented to
increase demand for borrowing to increase inflation and more importantly, to lower short-term
Treasury yields.4 And lastly, the Federal Reserve took on the final round of quantitative easing,
or QE3, at the start of September 2012. The initiative would enable the Federal Reserve to
purchase $40 billion worth of mortgage-backed securities per month, alleviating banks and
financial institutions from holding more toxic assets, usually consisting of subprime mortgages.5
So far, the process of quantitative easing has provided some beneficial effects such as increased
economic growth and liquidity in the U.S. However, there are still many drawbacks persisting
from the results of quantitative easing.
Even though the purpose of quantitative easing was to provide monetary accessibility and
liquidity to the public, most of the cash from the Federal Reserve is held in excess reserves by
major banks and financial institutions. When quantitative easing is applied, the process of
purchasing debt securities by the central bank caused the fed funds rates to be lowered
to approximately 0%, interest rates at which depository institutions would lend reserves to other
banks at a certain amount overnight. With the fed funds rate currently fluctuating between 25 to
50 basis points (e.g. .5% = 50 basis points), the interest on excess reserves (IOER) still remained
at a higher rate of 50 basis points. Therefore, banks are more likely to hold cash in excess
reserves as they would earn more with the IOER than the rate from lending reserves. In other
words, quantitative easing provides an arbitrage for banks to earn a higher interest on excess
reserves, since the IOER is considered risk-free and more profitable than conventional lending,
which carries a certain level of risk.
3. As of November 2016, the Federal Reserve currently holds $4.41 trillion of total assets,
with a vast majority of holdings that consist of U.S. Treasuries and mortgage-backed securities.6
QE1, QE2, and QE3 not only affected the Federal Reserve’s balance sheet with more assets and
liabilities, but many banks experienced the impacts as well. The balance sheets of private banks
did not experience inflated numbers compared to the Federal Reserve’s, but instead, a
composition change from the amount of security holdings shifting to reserves on the assets side.7
When the Federal Reserve purchased mortgage-backed securities in QE1, it was implemented to
save the commercial banks and other depository institutions from incurring further asset losses
and risks of long-term bank failures.8 QE1, in addition with the Federal Reserve’s purchase of
U.S. Treasuries from QE2 and QE3, have motivated banks to increase excess reserves, the
amount of holdings to absorb sudden losses from loan defaults, cash withdrawals, or any
macroeconomic circumstances. However, the objective of banks holding more excess reserves
does not always provide benefits for the U.S. economy as a whole. Despite the spread between
the fed funds rate and the IOER, the amount of cash in excess reserves cannot be lent out to the
public as ordinary loans, since lending only applies to depository institutions. The process of
quantitative easing does not directly provide monetary accessibility for the public to spend and
lend, since the transaction of the Federal Reserve purchasing securities is only directed toward
commercial banks and financial institutions.
Nevertheless, quantitative easing is more than just achieving efforts to increase the
money supply or prevent bank failures; it is also aimed to influence long-term government bond
yields by lowering short-term rates in the yield curve. To understand the concept of the yield
curve, it is a line chart that reflects the relationship between interest rates and the maturity of
government securities. In this case, the Federal Reserve can only control short-term rates by
4. buying or selling securities when it seeks to target long-term rates at a certain level. During the
phase of QE2 and QE3, the yield curve becomes flattened as the Federal Reserve continues to
purchase debt securities, thus pushing down short-term rates near 0%.9 The shape of a flattening
yield curve does not always predict the future of the U.S. economy, even when the process of
quantitative easing still persists. As a result of the flattening yield curve, this caused a higher
demand for long-term bonds, resulting in lower long-term yields. Lower yields would enable
more borrowers like new homeowners with mortgage loans or startups with long-term debt to at
affordable rates. As lending continues to increase based on current economic and banking
situations, more economic growth in the U.S. could accelerate in the long-run.
Inflation is an important economic factor that can be impacted as a result of quantitative
easing. It was believed that quantitative easing would lead to hyperinflation for the U.S.
economy; nevertheless, this did not occur as the economy was already in a deflationary state
after the recession.10 Before QE2 took place, the inflation rate was 1.1% as of November 2010,
which was below the standard rate of 2%.11 A low inflation rate, or deflation, can signify slower
economic growth, due to the anticipation of high unemployment and falling prices as consumers
would delay purchases and spending, thus causing prices to fall precipitously.3 The
implementation of QE2 and QE3 was designed to break the cycle of deflation; therefore, the
purpose of increasing the money supply would cause the inflation rate to rise, increasing prices
to drive employment and consumer spending. So far, the current inflation rate for the U.S. is at
1.6% through 12 months ending October 2016.13 Even though the current inflation rate is still
short from reaching 2%, the rate is still expected to rise as the economy continues to grow.
At this point in time, we believe that the current phase of quantitative easing will be able
to achieve more for the desired effects of the U.S. economy in the near future. Overall, the
5. process of QE1, QE2, and QE3 did manage to achieve its goal on jumpstarting the U.S. economy
from the effects of the recession. QE1 alleviated banks and financial institutions from holding
mortgage-backed securities during the subprime mortgage crisis in 2008. However, it did not
accomplish the specific task of spurring high economic growth as banks continued to accumulate
more excess reserves instead of lending with other depository institutions. The implementation
of QE2 and QE3, in response to the insufficiencies of QE1, have accomplished more to spur
economic growth by combating deflation and influencing the yield curve. As of now, it is still
too early to determine whether if the three quantitative easing measures have fully succeeded in
sustaining the U.S. economy for the long-run.
