Quantitative Easing, a rather unconventional monetary policy, has found widespread use in

recent times. Many major central banks, such as the Federal Reserve, Bank of Japan, and the
European Central Bank, have resorted to this policy to kick start economic growth. In a previous
article, we discussed the transmission mechanism of QE. Typically, QE works by simultaneously
injecting liquidity and pulling down interest rates. This, in turn, stimulates borrowing and
spending activity, which, in turn, promotes economic growth. In this article, we add perspective
to the theory put forward by delving into the U.S. experience with QE.
In 2008, the world faced its worst economic crisis since the Great Depression. The crisis, which
found its roots in the U.S. housing market, had quickly spread to the U.S. financial sector, and
then to the global financial sector. It brought down with it the investment banks, insurance
companies, commercial banks, mortgage lenders, and a number of companies who relied on
credit. Furthermore, the contagion spread to major economies across Europe and Asia that had
dabbled in the American real estate sector, wiping out over 30% of the value of a number of
major economies. The result was a widespread slowdown in growth, in the U.S., and in the
world. (See Figure 1)

Quantitative Easing Timeline

In the wake of the global financial crisis, the Federal Reserve used several rounds of QE to get
the economy back on track. In this, the Fed started growing its balance sheet by purchasing
government bonds and mortgage-backed securities. The first round of QE, also later called QE1,
was initiated in November 2008. The Fed proposed to buy ~$100 billion of agency debt and
~$500 billion of mortgage-backed securities. The first round was further extended in March
2009, where the Fed used another $850 billion to purchase mortgage-backed securities and debt.
Furthermore, the Fed also channeled another $300 billion into longer-dated treasuries. In
November 2010, the Fed announced yet another bond buying program. This involved buying
$600 billion worth of longer-dated treasuries by mid 2011. This was called QE2. In September
2011, the Fed initiated a new maturity extension program, also called Operation Twist, with the
aim of increasing the average maturity of the banks treasury portfolio. Hence, the Fed purchased
$400 billion worth of treasuries with maturities between 72 and 360 months, and sold off an
equal amount of treasuries that had maturities in the 3-36 month range. In September 2012, the
Fed announced QE3, where the central bank would spend close to $40 billion per month
in mortgage-backed securities. This, along with Operation Twist, was supposed to account for
$85 billion worth of long-term bond purchases. In December 2013, the Fed indicated a taper,
where the $85 billion spent per month would be reduced by $10 billion going forward. In
October 2014, the Fed indicated an end to the QE3 program.

How has QE worked?

Unconventional monetary policy, such as QE, is typically used when conventional monetary
policy fails, i.e. when short-term nominal interest rates are already close to zero such that they
cannot be reduced any further to stir economic activity. Now, in QE, the Fed typically buys debt
and MBS from commercial banks, in exchange for money that is created electronically. This, in
turn, swells the Feds balance sheet by the amount of assets purchased. (See Figure 2)

Now, when the Fed buys these financial instruments, the money supply in the economy
increases. This is evident when one looks at the U.S. monetary base, which shows that total
amount of currency that is in circulation with the public, or held as commercial bank deposits in
central bank reserves. (See Figure 3) However, commercial banks did not give all of this money
out as loans. In fact, they kept a large proportion of this money created as excess reserves with
the Fed. (See Figure 4)

In spite of this, the amount of money that is injected into the economy creates somewhat of a
disequilibrium, where individuals are holding more cash than they would like to. Hence, they put
this extra cash into assets such as bonds, stocks, and real estate. This, in turn, bids up the price of
these assets and consequently reduces the yield on these assets. Note that the same mechanism is
at work even with the agency debt and MBS that the Fed is purchasing. Since the Fed is buying
up these instruments, it automatically creates demand for them, which pulls up the price and
consequently reduces the yield. Hence, a new equilibrium interest rate is reached in the economy
that is lower than what it was previously. This lower interest rate stimulates borrowing, investing,
and spending activity, to kickstart economic growth.

Has QE Really Worked?

A broad look at economic factors suggests that QE in the U.S. has worked. The two broad
metrics, economic growth and the unemployment rate, which were crucial in deciding when the
taper would come about, have definitely improved drastically since the economic downturn.
However, empirical evidence suggests a difference in the impact that the various rounds of QE
have had on the economy, with most studies agreeing that QE1 was most effective, with
subsequent rounds having less effect. Empirical evidence also suggests that QE successfully
lowered nominal interest rates on different financial instruments (agency debt, MBS, corporate
bonds), however the intensity varied depending on the type of instrument and maturity. However,
while the change in interest rates are relatively easy to see, it is hard to isolate QEs impact on
real economic indicators.

Experts also seem to be divided on whether QE in the U.S. was actually an effective antidote to a
weak economy, or whether it has sown the seeds for more problems going forward. Proponents
of QE believe that the policy was effective in lifting the U.S. out of the slump that it had been
witnessing. In fact, according to a BBC report, the then Federal Reserve Chairman, Ben
Bernanke, suggested that QE1 and QE2 were responsible for increasing economic activity by
3%, and adding close to 2 million jobs in the private sector, in comparison to a world without
QE. Other economists have attributed the recovery in housing sales, car sales, business
expansion, etc., to the low interest rate environment created by QE.
However, critics believe that the recovery in the U.S. has not been exceptional. For one, the
economy is yet to reach the stage that it was at during the pre-crisis period, in spite of such a
powerful stimulus working on it. Critics also worry about what QE might have in store for the
future. For one, the policy can lead to high inflation, which is a by-product of injecting liquidity
into the economy. While this has not been true so far in the U.S., since a larger proportion of the
new money created is held as excess reserves with the Fed, rather than being circulated among
people, banks could at some point decide to give out these excess reserves as loans.
Another potential adverse consequence is punishing responsible behavior. Since QE drives down
interest rates, savers, who in the U.S. case are mostly the older generation, have been punished,
while borrowers, who are generally younger, have been rewarded. In some cases, irresponsible
borrowers were also rewarded. According to one study by Swiss Re, the Feds policies have cost
savers up to $470 billion, while another study by McKinsey puts the quote at $360 billion. Either
way, QE has, in a way, negatively reinforced good behavior.
Last, but not the least, is the impact on the U.S. and the global financial markets at large. Clearly
when borrowing becomes cheap, people could direct the money into high risk, high reward
assets. This occurred in the wake of QE, when capital started moving from the U.S. to riskier
emerging markets. The result was strengthening emerging market economies, and emerging
market currencies. However, when the Fed announced the QE taper, these funds started returning
back to the U.S., leaving many emerging economies in trouble.
In conclusion, QE has been effective in sailing the U.S. through the recession. However, it could
very well have consequences for the stability of the U.S. financial system and the global
financial system, since it is, after all, an artificial stimulus. Only time will tell if QE in the U.S.
has been instrumental in pulling the U.S. economy out of a crisis, or whether it has just set the
stage for the next crisis.

How does monetary policy influence

inflation and employment?
In the short run, monetary policy influences inflation and the economy-wide demand for goods and services-and, therefore, the demand for the employees who produce those goods and services--primarily through its
influence on the financial conditions facing households and firms. During normal times, the Federal Reserve
has primarily influenced overall financial conditions by adjusting the federal funds rate--the rate that banks
charge each other for short-term loans. Movements in the federal funds rate are passed on to other short-term
interest rates that influence borrowing costs for firms and households. Movements in short-term interest rates
also influence long-term interest rates--such as corporate bond rates and residential mortgage rates--because
those rates reflect, among other factors, the current and expected future values of short-term rates. In addition,
shifts in long-term interest rates affect other asset prices, most notably equity prices and the foreign exchange
value of the dollar. For example, all else being equal, lower interest rates tend to raise equity prices as
investors discount the future cash flows associated with equity investments at a lower rate.
In turn, these changes in financial conditions affect economic activity. For example, when short- and long-term
interest rates go down, it becomes cheaper to borrow, so households are more willing to buy goods and
services and firms are in a better position to purchase items to expand their businesses, such as property and
equipment. Firms respond to these increases in total (household and business) spending by hiring more
workers and boosting production. As a result of these factors, household wealth increases, which spurs even
more spending. These linkages from monetary policy to production and employment don't show up immediately
and are influenced by a range of factors, which makes it difficult to gauge precisely the effect of monetary
policy on the economy.
Monetary policy also has an important influence on inflation. When the federal funds rate is reduced, the
resulting stronger demand for goods and services tends to push wages and other costs higher, reflecting the
greater demand for workers and materials that are necessary for production. In addition, policy actions can
influence expectations about how the economy will perform in the future, including expectations for prices and
wages, and those expectations can themselves directly influence current inflation.
In 2008, with short-term interest rates essentially at zero and thus unable to fall much further, the Federal
Reserve undertook nontraditional monetary policy measures to provide additional support to the economy.
Between late 2008 and October 2014, the Federal Reserve purchased longer-term mortgage-backed securities
and notes issued by certain government-sponsored enterprises, as well as longer-term Treasury bonds and
notes. The primary purpose of these purchases was to help to lower the level of longer-term interest rates,
thereby improving financial conditions. Thus, this nontraditional monetary policy measure operated through the
same broad channels as traditional policy, despite the differences in implementation of the policy.