An idiot's guide to quantitative easing: what QE is, how it works, and why bad news became good news
The Fed cannot buy the government's bonds from the government. So it lets the banks buy them first, and buys them from the banks a few days later, at a premium. That is the whole trick.
A funny thing happened on the way to Wall Street in the summer of 2012. The economic news was as dark as the ink it was printed in, and the stock market went up on every piece of it. The reason was not hard to find. The Federal Reserve had been signalling a third round of quantitative easing, QE3, and the market had learned that bad news made it more likely. Somewhere in the Fed’s building, the reasoning went, a clerk would soon be typing numbers into the reserve accounts of the banks, and hundreds of billions of dollars that had not existed the day before would exist. Bad news was good news. This page explains what that means.
Three reasons not to feel stupid
If you do not understand quantitative easing, there are three reasons not to feel bad about it. The first is that you have found a guide. The second is that the people doing it do not fully understand it either: it had been tried once at scale, in Japan after 2001, and Japan had not come back from the place it went. The third is that money creation is a subject on which economists have theories, plural, and disagree about which one describes the world. QE is an experiment in one of those theories, run on the largest economy on earth.
The six steps
Here is the mechanism, stripped of jargon.
- The central bank announces that it will buy a stated quantity of government bonds from banks over a stated period.
- The Treasury issues bonds to finance the government’s deficit.
- The banks, knowing there is now a ready buyer for those bonds, buy them from the Treasury.
- The banks sell some of the bonds to investors and sell the rest to the central bank at a small premium.
- The central bank pays for them by creating a deposit in each bank’s reserve account. That deposit did not come from anywhere. It is a number that did not exist until it was typed.
- The central bank now holds the bonds. It is the government’s creditor.
By law the Fed may not buy bonds directly from the Treasury, because that would be the government printing money to pay its own debts, which is called monetising the debt and is what Weimar Germany and Zimbabwe did. The one step in the middle, the banks holding the bonds for a few days, is what keeps QE on the right side of that law. Since the Fed announces in advance what it will buy, the banks are never at risk, and the Fed is in every practical sense the primary buyer of the government’s debt. It is a circus with one hoop.
What it is for, and what it did
The stated purpose was to lower long-term interest rates and to leave banks holding so much cash that they would lend it. The Fed’s mandate from Congress is stable prices and maximum employment. By that mandate, QE1 and QE2 had failed: unemployment had barely moved after either round. What had moved was the price of assets. Banks that sold bonds to the Fed did not lend the proceeds to small businesses; they bought stocks and other bonds, and smaller investors, knowing the banks would buy, bought ahead of them. Each round of QE lifted the market and each pause let it sag, so that the economy and the stock market moved like the two ends of a seesaw. The result by 2012 was a market that many took as proof of recovery and that looked, on this reading, like a bubble inflated by newly created money on a narrow base of buyers.
Who objected
The objections did not come only from outside. Richard Fisher, president of the Dallas Fed, had argued in 2010 that further easing would do little for employment and much for speculation, and dissented repeatedly. Jim Rogers, the investor, said the Fed chairman had caused the stock bubble that led to the housing bubble and was now printing more money, and that he could not get a job as a banker. The polite version of the objection was that QE treated a solvency problem as a liquidity problem. The impolite version was that it was a Ponzi scheme in which the government issued debt, the central bank bought it with money it created, and the interest the government paid on the debt was remitted back to the Treasury, so that the debt cost nothing as long as nobody asked who would ever buy it back.
Was QE3 the apocalypse?
The question in the original title was whether a third round would be the fiscal apocalypse its critics predicted. The honest answer in August 2012 was that nobody knew, because nobody had done this before at this scale and stopped. The risk was not the immediate one, inflation in the shops, which QE1 and QE2 had not produced. It was the exit: a central bank holding trillions of dollars of bonds cannot sell them without driving up the interest rates it spent years pushing down, and a government that has grown used to borrowing at almost nothing has no plan for borrowing at something.
Later note. QE3 was announced on 13 September 2012, open-ended, at 40 billion dollars a month in mortgage bonds, raised to 85 billion in December. It ended in October 2014, having taken the Fed’s balance sheet to about 4.5 trillion dollars. The exit problem described above became the story of 2018, 2019 and, in a larger form, of 2022.