By Andy Ewing, PayScale.com
Early in September, the Fed announced that they would be pursuing a third round of quantitative easing (QE3). There has been plenty of debate over how well the first two rounds performed and how this round is expected to perform, but I thought I would take the tack of trying to explain what quantitative easing is and how it affects the everyday American citizen.
Open Market Operations and the Fed
When you listen to a journalist try to explain quantitative easing, you will almost always hear some version of this phrase, “the Fed is printing money and buying bonds.” What they neglect to mention is that the Fed buys or sells bonds every time they target interest rates, even in a “normally-functioning” economy.
Through open market operations, the Fed buys or sells bonds to lower or raise their target of the federal funds rate, the short-term rate that gets charged on overnight interbank loans. When the Fed buys bonds, they inject more cash into the banking system, pushing down the interest rate in this interbank loans market. Since interest rates tend to move together, other interest rates in the economy usually follow suit. When they want to raise the interest rate target, they perform this process in reverse.
When we appear to be heading into a recession, the Fed typically lowers their interest rate target in an effort to spur borrowing and spending. They did just this as we headed into the Great Recession. We’ve been at the target federal funds rate of 0-0.25 percent since late-2008.
Quantitative Easing Explained
This is where quantitative easing comes into play. The Fed can’t do much more to change those interest rates that are already at zero, but it may be able to decrease interest rates that are not quite there yet. Anyone who has taken out a mortgage knows that interest rates on longer-term loans are usually higher than shorter-term loans. So, when short-term rates hit zero after the Fed works its traditional magic, long-term rates still may be a few points higher, even if they have inched down a bit.
Quantitative easing is simply the Fed buying longer-term assets (in addition to the shorter-term assets they are already buying) to try and push down long-term rates even further. In QE3, the Fed is buying mortgage-backed securities, and “will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, [this] should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.” (For the graphically inclined, Mark Thoma has a great explanation of QE2 using yield curves.)
How Does It Affect Me?
If you’re in the market for a new house, a new car, or if you’re a small business owner looking to secure a loan, this should be welcome news, assuming the bank agrees to give you the loan in the first place. A record low 30-year fixed rate mortgage of 3.49 percent seems like a pretty good deal.
What’s the Catch?
As with any policy lever the Fed chooses to pull, yes, there is a catch. There is concern among some economists that this continual injection of more and more money into the economy will lead to higher rates of inflation if the policy is not wound back soon. This is a valid concern, but the data has yet to point in that direction.
A more grave concern is if this latest round of quantitative easing leads us into a liquidity trap—the idea that if there is no significant difference between the return on holding cash and the return on longer-term assets, people will just hoard cash. Whether or not that will happen on a large scale, and how the Fed will handle the resulting challenges, is a topic for another blog post.
Andy Ewing is an economist and writer living on Bainbridge Island, Wash. He earned his Ph.D. in Economics from the University of Washington. He has taught economics at Eckerd College and conducted research in the economics of education.
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