As the US economy slowed to 1.5% in the second quarter of 2012 from the revised estimate of 2% in the first quarter, expectations in the marketplace have started gathering pace that Federal Reserve will announce QE3 (quantitative easing) to support the economy. Similarly, in Europe, as the borrowing cost in some countries remains high, markets are again expecting European Central Bank (ECB) to step in and do some quantitative easing.
What is quantitative easing?
It is an “unconventional” tool in the hands of central banks that allows them to buy assets from the markets to inject a specified quantity of money into the system. It is normally used when the monetary policy becomes ineffective. For example, if the credit conditions are tight in the market despite bringing down the policy rate close to zero, the central bank may choose to inject money by way of buying bonds from the market.
The term became popular after the Federal Reserve announced in 2008 that it will buy mortgage-backed securities backed by government sponsored enterprises with an objective to “reduce the cost and increase the availability of credit for the purchase of houses”. The action got termed as QE1. Later, in August 2010, the Federal Reserve declared that it will buy additional long-term government securities worth $600 billion, this came to be known as QE2, which ended in the second quarter of 2011. By the end of the two rounds of easing, the balance sheet of the Federal Reserve expanded by $1.25 trillion. Simply put, the US central bank had pumped in $1.25 trillion in the system in about three years.
Quantitative easing in other countries
Before the term became popular, quantitative easing was used in Japan in the beginning of March 2001 when even zero interest rates failed to kick-start economy activity and push prices. In Japan, it was then known as quantitative easing policy (QEP). During the ongoing crisis, apart from Federal Reserve, Bank of England, too, has tried QE; ECB also did some bond buying, though on a much smaller scale.
The side effects
There can be different objectives for a central bank for taking the QE route. It could be to reduce friction in the financial system or to encourage lending and push up consumer prices. However, the unintended consequences of easing may prove dangerous. Too much money pumped into the financial system can fuel commodity and asset prices. Since global financial markets and commodity prices are interlinked and interdependent, it could fuel asset bubbles and lead to high inflation in different parts of the world. Therefore, it is important for central banks to be very careful about the extent easing can be done. They should also have an exit strategy in case it starts becoming inflationary.