Can somebody please explain to me what quantitative easing is in simple terms?
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Quantitative easing is a monetary policy action where a central bank purchases predetermined amounts of government bonds or other financial assets in order to stimulate economic activity.
In layman’s terms, when you have a bond, you have given the government money at some point in the past in exchange for a promise for more money at some point in the future (that is what a bond is). That means that you don’t have money to spend _today_ – your money is already gone, tied up in a bond that will pay out in the future. Economies work when money is being spent and circulated, so they buy your bond from you today for _some_ of the future value, giving you money you can spend right now on other things.
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Taking it back to the beginning, the government issues bonds. It will issue them for a current market rate, which varies depending on the tenor (length of time) of the bond – a 5-year bond will have a different rate than a 10-year, for example. So for example, the 5-year might be issued at 5%, and the 10-year might be issued at 6%. The face value of the bond is the “par” value. Let’s say it’s a $1000 bond. Because of those interest rates, the 5-year will pay $50 per year, and the 10-year will pay $60.
Even though it was issued at that price, it can still be bought and sold at a “premium” (more) or “discount” (less).
Let’s say those bonds were issued one year ago at those rates. But today, the comparable rates are 6% and 7%, respectively. If I want to sell my bond, no one will give me $1000 for it because if they went to the government and got a bond at the prevailing rate they could get more per year ($60 and $70, respectively). So what to do? Well, if I want to get 6%, and I know the bond will pay $50, then it’s just math to figure out the price (we’re going to ignore accretion to maturity for a second, which does make the math more complex than I’m about to do – this isn’t for the actual numbers, but just so you see the point). $50 / $833 = 6%. You would pay me less than par for the bond, because the interest rates have gone up. The opposite is true also – if rates go down (say, to 4%), my bond is now worth more ($50 / $1250 = 4%). So, yields go up, price goes down, and yields go down, price goes up.
The *inverse* of all of this is also true – if price goes up, yields go down. So if the central bank starts buying bonds, the price of the bonds will go up. If the price goes up, that drives the market yield – the rates people will compare other bonds to – down.
By buying bonds, it’s pushing the price of bonds up, and rates down. It also increases the money supply, putting more money into the market to allow that cash to be used.
QE takes bonds out of circulation and replaces it with cash. There is now excess cash in the market, which gets spend on stuff and stimulates the economy. Maybe. In reality it mostly stimulates inflation.
The government issues bonds to borrow money. A bond is a specific type of loan, which can be traded from one person to another. Under normal circumstances, the yield on those bonds is no different from a bond issued by any other institution: A business, a city, whatever.
However, QE2 is a system whereby the Federal Reserve uses money drawn from the U.S. Treasury (thin air, in actuality, since the Treasury can print dollars) to buy those bonds. So, in effect, the government is printing money and stuffing it into the pockets of people who are holding government debt, on the undertaking that they’ll take that money and invest it elsewhere.
tl;dr The government buys back it’s bonds to reduce inflation and stimulate the economy.
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If the government needs money *today,* it sells a bond which is a promise the government will pay the price of the bond back + some percent interest (like 4% generally). But if people think inflation will be faster than 4%, they would rather stick their money somewhere else. Except the government needs money *today*, so it sells bonds for 5%, then 6%, etc. But in doing that, it’s a feedback loop which makes inflation go higher because now they’re actively putting more money in circulation.
QE is when the government flips direction and starts spending lots of money to buy up those high interest bonds. This puts the money that would been put in the economy 5 years from now in circulation today, which in theory stimulates the economy. At the same time, the **total** money being put in the economy goes down, since they’re no longer paying interest payments. And as a final bonus, since the supply of bonds is going down the price bumps up a bit, so if they need to sell bonds again in the future they will get a better price.
It’s printing even more money.
The Federal Reserve is in charge of deciding how much money to print. If there’s not enough money they’ll print more and if there’s too much they’ll print less or delete some. But there’s a problem with printing money, and that’s deciding who gets to have the new money. They could give it to everyone, but that’s a logistical nightmare. They could give it to the government, but they’re not allowed to treat the government specially.
Before about 2008, printed money was given to banks in the form of interest. The Federal Reserve is also the central bank – it’s where banks put their money. So the Federal Reserve could print more money to each bank depending on how much money the bank had. If there was too much money they’d give less interest and if there wasn’t enough money they’d give more interest.
In the 2008 crisis for some reason they decided this wasn’t a fast enough way of printing money. What they decided to do instead was to go to Wall Street and buy things from Wall Street. What did they buy? Well, they weren’t there to gamble – they just needed to put money into the economy – so they picked the safest thing that is traded on Wall Street, which is government bonds – government IOUs. It doesn’t count as treating the government specially, because they bought the bonds from the Wall Street banks, not actually from the government. Banks still traded bonds with each other like before – the bond market works a lot like the stock market – but sometimes, the market ended up matching a bank’s trade with the Federal Reserve, and the bond disappeared into the dark abyss of the Fed’s balance sheet, and the money magically appeared in the bank’s pocket, and this was how the Fed put money into the economy.
This program never ended and many people believe it permanently fucked up both the amount of money and also the bond market.
I don’t know why it’s called “Quantitative Easing”. It might be a euphemism. The EU’s version has a better name – they call it “Outright Monetary Transactions” – “screw this interest rate shit, we’re just gonna straight-up buy stuff.”
Lets say you are rich, and you notice that all your friends are very poor, and they are struggling with having enough money to pay for food and their basic needs.
You have a few options, you could:
– Give them money for free
– Lend them money
– Tell them to have a yard/garage sale, and buy up all the stuff that they don’t need.
Quantitative easing is the governments version of the last option. To infuse the economy with cash, the government buys up a large portion of investment items called securities (usually stocks and bonds). This allows the holders of these items to liquidate (sell off) their investments. Normally when a business, or person needs to generate money quickly, the last thing that they want to do is sell their assets. Consider how you would feel selling your car, for grocery money. You would be too motivated, and be forced to sell for too low, and lose a bunch of money on your car. But if you have to get the money, then you have to.
Having the government, buy your car for the market rate, right now. Gives you a good return, lets you get the money you need, and then when you are back on your feet, you can either buy your car back, or a new one. Secure in knowing that you didn’t lose much in the situation.
This in theory allows the economy to bounce back quickly after a recession.
Disclaimer: The government does not do Quantitative Easing on the level of individual people, it is often buying thousands of bonds from banks. I only compared to individual items as I think for ELI5 it makes it clearer what is going on.
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