In late 2008, U.S. economy was almost non-existent and created a recession. The Federal Reserve had already reduced the interest rate to almost zero and decided to adopt a non-traditional policy known as quantitative easing (QE). The policy is the purchase of long-term government and private mortgage-backed securities by central banks to make credit available to stimulate demand. QE involved the Federal Reserve purchasing long-term Treasury bonds, rather than short term.
The assumption was investment spending decisions were typically based on long-term interest rates, such as home mortgages. With traditional monetary policy, the idea is because short-term and long-term interest rates rise and fall together, lowering short-term rates would lower long-term rates and stimulate investment spending. QE attempted to directly lower long-term interest rates. (Learning, n.d.) Instead of using the traditional monetary policy of purchasing Treasury securities, the Federal Reserve purchased private mortgage-backed securities (MBS) using the QE policy.
The financial crisis included the failure of MBS which were financial assets bundling individual mortgages. When the housing market collapsed, and mortgages defaulted, the worthiness was unknown. Therefore, the Fed was pushing long-term interest rates down and removing the “toxic assets” from the balance sheets of private financial firms, strengthening the financial system (Learning, “Macroeconomics Fall 2018,” n.d.).
What were the claims made? High oil prices, and a decline in home prices during the great recession beginning on December 2007. The United States also had a large foreclosure market because of the bad loans approved by banks. It hurt the mortgage and lending banks. Countrywide agreed to be purchased by Bank of America and Northern Rock in 2008. On March 16, 2008, the FOMC held an emergency meeting because of the imminent collapse of Bear Stearns (the 5th largest investment bank in the U.S.). The Federal Open Market Committee (FOMC) approved financing JP Morgan to purchase Bear Stearns during the meeting.
On September 15, 2008, Lehman Brothers, the fourth largest investment bank in the U.S. filed for Chapter 11. The Dow Jones dropped 2,300 points, equivalent to a 20.6% drop, that day. This confirmed how bad the US economy was and there was no easy solution to get out of the recession. FOMC decided to apply quantitative easing (QE) to help the U.S. economy to lower long-term interest rates and stimulate the economy. QE occurred in three phases.
The first phase, or QE1, began in November 2008 and lasted 16 months. The Fed purchased $600 billion in mortgage-backed securities from Fannie Mae and Freddie Mac. Spending peaked at over $2.1 trillion on purchases of Treasury, Mortgage, and other securities. Even with the Fed doing all this, the dollar was still on a consistent decline. It hit the highest mark only when the Fed halted it. In June 2010, the Fed announced the end of QE1 because they felt the economy was growing.
The second phase, called QE2, began in November 2010 when the Fed believed the economy wasn’t growing as strongly as desired. So, they purchased $600 billion in Treasury securities and added another $250-300 billion in treasuries from the profits from previous investments. QE2 lasted eight months and came to an end in June 2011. The Fed maintained a portfolio of $2 trillion and gold prices increased again when it ended.
The third phase, known as QE3 began in September 2012 and was different from the previous two. The Federal Reserve decided to make purchases on a monthly basis instead of all at once. The first purchase was $40 billion of mortgage-backed securities a month. On December 2012, it was increased to $85 billion a month.
Bernanke stated that “What we’re doing is fundamentally different from the Japanese approach.” Instead, the Fed would focus on the asset side of its balance sheet. The intent was not simply to enhance bank liquidity and to thereby encourage the growth of the money stock, The Fed’s goal was to reduce yields on chosen long-term assets. It was aimed not at enhancing the aggregate supply of credit available to the market, but at allocating credit to specific segments of the market that were seen as the most “credit constrained.” QE increases the supply of bank reserves, but not increase the overall supply of credit as long as banks held new reserves as excess reserves (Thornton & MOBI, Cato Institute, 2015).
In an article in The Regional Economist, Stephen Williamson, a former vice president and economist at the St. Louis Fed, cited a 2016 paper that summarized the empirical work evaluating the effects of QE. “The weight of the results was interpreted by those economists as favoring the standard central banking narrative concerning QE. That is, according to the narrative, QE works much as conventional accommodative policy does—it lowers bond yields and increases spending, inflation, and aggregate output,” Williamson wrote.
However, he cited a few reasons to be skeptical of this interpretation. In particular, he noted:
• One set of studies only looks at how asset prices react in a short window around a policy announcement.
• The authors of the 2016 paper noted econometric problems in the studies they looked at.
• The empirical work examined didn’t measure the advantage central banks may have in transforming assets when they conducted QE (Federal Reserve Bank of St. Louis, “Does Quantitative Easing Work as Advertised?” 2017).
The main mechanism by which QE would stimulate the economy is by ensuring inflation does not go below the target rate. There may be some negative effects from applying QE such as:
• An increase in the money supply too quickly would cause inflation.
• Banks may not choose to lend money, but instead, choose to invest it. In turn, the economy is not stimulated.
• Depreciation of the local currency would be detrimental to the import industry. It would create higher costs for both importers and consumers.
• It would benefit the upper-income bracket and increase their wealth and create income inequality. The lower income bracket would not be provided for.
It could affect economic sectors such as banks, corporations, and households. Banks then use QE buy financial assets or other financial institutions at a low price and sell at a higher price. The effect to corporations or other financial institutions would be to sell at a lower price and could be at a loss. Banks will set a yield rate and aims to achieve the zero lower bound. It has a negative effect on the banks because they will receive a small amount of yield. Households have a greater chance to borrow money from banks.
A company’s cost of capital, capital structure, and stock price values relies on the mechanism of interest rates with quantitative easing. The aim of quantitative easing is to increase the supply of money in an economy, which tends to depreciate the exchange rates of a particular country through the interest rate mechanism (Phil1). A lower interest rate causes a capital outflow that affects the demand for a country’s currency, causing a weaker currency. QE affects the company’s cost of capital by lowering the rate of return on an investment due to a lower interest rate. The capital structure would then be affected since the rate of return cannot be achieved. The value of its stock price will decrease if using the currency of the country. With weaker currency, the demand of foreign countries to purchase from another country will decrease, causing the value of stock to also decrease.
Saint Leo Universities core value of excellence is to work hard and ensure a student develops character, learn skills, and assimilate knowledge to become morally responsible leaders. Quantitative easing is an example of excellence because it encouraged the Federal Reserve to try a new way of stimulating the economy.