Introduction to Quantitative Easing and Its Role in the Economy

Quantitative easing (QE) is a monetary policy tool used by central banks, such as the Federal Reserve in the United States. It involves the central bank purchasing large quantities of financial assets, like government bonds, from the open market. This process is designed to inject liquidity into the financial system and stimulate economic growth. However, the effects of QE on interest rates are complex and multifaceted.

Understanding the Fundamentals of Money Supply and Interest Rates

The relationship between the money supply and interest rates is not straightforward. Historically, the money supply has been influenced by factors such as new paychecks, wage increases, and consumer spending. However, interest rates are primarily controlled by the central bank, such as the Federal Reserve, rather than market forces.

How Does Quantitative Easing Increase the Money Supply?

Quantitative Easing increases the money supply by injecting more money into the financial system. The central bank purchases treasury bills, mortgage-backed securities, and other financial assets, thereby increasing the liquidity in the market. This expanded money supply can lead to inflation, causing the purchasing power of currency to decrease over time. As a result, the interest rates may drop as the central bank seeks to maintain balance in the economy.

Impact on Inflation and Interest Rates

Increased inflation due to rising money supply can incentivize people to move their cash into assets and equities, which can offset the effects of QE. This creates a dynamic where the central bank might reduce its QE measures to prevent excessive inflation. Eventually, as inflation rises, the central bank might raise interest rates to stabilize the economy and to achieve a balance between the return on equities and assets.

The Current Monetary Policy Environment and QE

In today's monetary policy environment, QE is often implemented when interest rates are already at or near the Zero Lower Bound (ZLB), which is the point where the central bank cannot lower interest rates further. Sustained QE can lead to an increase in inflation expectations, which in turn can push nominal interest rates higher.

Once sufficient QE has been implemented, the central bank will exit the ZLB and begin to raise interest rates to maintain economic equilibrium.

The Role of QE in Interest Rates

Quantitative Easing directly affects interest rates by driving up the prices of the assets it purchases. For example, the Federal Reserve's purchase of trillions of dollars in mortgages and treasuries has significantly bid up their prices. As bond prices rise, so do the yields, which result in lower interest rates. The ongoing monthly purchases of $120 billion continue to maintain a low-interest rate environment.

Economics 101 teaches us that when the price of one asset class rises, the prices of substitutes in that class also rise. With sky-high treasury prices, we can expect the stock market to also be high. Banks would not be able to offer mortgage rates of 2.5% in the face of 5.4% inflation, as this would not be a sustainable situation for the economy.

Conclusion

Quantitative Easing plays a significant role in shaping the economy's monetary policy. While it can lead to a temporary lowering of interest rates and increased asset prices, the long-term effects on inflation and interest rates remain complex. Central banks must carefully manage these policies to maintain economic stability and prevent inflation from spiraling out of control.