Can somebody please explain to me what quantitative easing is in simple terms?

Question

Can somebody please explain to me what quantitative easing is in simple terms?

In: 118

Answer 1

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.