Tuesday 15 August 2017

Investopedia: Quantitative Easing and Other Central Bank Monetary Policy Tools

Quantitative Easing
What is 'Quantitative Easing'

Quantitative easing is an unconventional monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity. Quantitative easing is considered when short-term interest rates are at or approaching zero, and does not involve the printing of new banknotes.
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BREAKING DOWN 'Quantitative Easing'

In quantitative easing, central banks target the supply of money by buying or selling government bonds. When the economy stalls and the central bank wants to encourage economic growth, it buys government bonds. This lowers short-term interest rates and increases the money supply. This strategy loses effectiveness when interest rates approach zero, at which point banks have to implement other strategies to kick start the economy. Another strategy they can use is to target commercial bank and private sector assets in an attempt to spur economic growth by encouraging banks to lend money. Note that quantitative easing is often referred to as "QE."
The Drawbacks of Quantitative Easing

If central banks increase the money supply too quickly, it can cause inflation. This happens when there is increased money but only a fixed amount of goods available for sale when the money supply increases. A central bank is an independent organization responsible for monetary policy, and is considered independent from the government. This means that while a central bank can give additional funds to banks, they can't force the banks to lend this money to individuals and businesses. If this money does not end up in the hands of consumers, the lending to the banks will not impact the money supply, and therefore will be ineffective at stimulating the economy. Another potentially negative consequence is that quantitative easing generally causes a depreciation in the value of the home country's currency. Depending on the country, this can be a negative. It is good for a country's exports, but bad for imports, and can result in the country's residents having to pay more money for imported goods.
Example

Quantitative easing is considered an unconventional monetary policy, but it has been implemented a lot in recent times. Following the global financial crisis of 2007-08, the U.S. central bank, the Federal Reserve, implemented several rounds of quantitative easing. More recently, the Bank of Japan and the European Central Bank have implemented QE.

For more information on the policy of quantitative easing, read Quantitative Easing: What's in a Name?
Quantitative Analysis

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Quantitative analysis refers to economic, business or financial analysis that aims to understand or predict behavior or events through the use of mathematical measurements and calculations, statistical modeling and research. Quantitative analysts aim to represent a given reality in terms of a numerical value. Quantitative analysis is employed for a number of reasons, including measurement, performance evaluation or valuation of a financial instrument, and predicting real world events such as changes in a country's gross domestic product (GDP) growth rate.
BREAKING DOWN 'Quantitative Analysis'

In general terms, quantitative analysis can best be understood as simply a way of measuring or evaluating things through the examination of mathematical values of variables. The primary advantage of quantitative analysis is that it involves studying precise, definitive values that can easily be compared with each other, such as a company's year-over-year revenues or earnings. In the financial world, analysts who rely strictly on quantitative analysis are frequently referred to as "quants" or "quant jockeys."

Governments rely on quantitative analysis to make monetary and other economic policy decisions. Governments and central banks commonly track and evaluate statistical data such as GDP and employment figures.

Common uses of quantitative analysis in investing include the calculation and evaluation of key financial ratios such as the price-earnings ratio (P/E) or earnings per share (EPS). Quantitative analysis ranges from examination of simple statistical data such as revenue, to complex calculations such as discounted cash flow or option pricing.
Quantitative Vs. Qualitative Analysis

While quantitative analysis serves as a very useful evaluation tool by itself, it is often combined with the complementary research and evaluation tool of qualitative analysis. For example, it is easy for a company to use quantitative analysis to evaluate figures such as sales revenue, profit margins or return on assets (ROA), but the company may also wish to evaluate information that is not easily reducible to mathematical values, such as its brand reputation or internal employee morale.

In a combined qualitative and quantitative analysis project, a company, analyst or investor might wish to evaluate the strength of a particular product that a company manufactures and sells. The qualitative analysis part of the project can be undertaken using tools such as customer surveys that ask consumers for their opinions about the product. A quantitative analysis of the product can also be initiated through the examination of data regarding numbers of repeat customers, customer complaints and the number of warranty claims over a given period of time.
Tapering


Tapering is the gradual winding down of central bank activities used to improve the conditions for economic growth. Tapering activities are primarily aimed at interest rates and at the management of investor expectations regarding what those rates will be in the future. These can include changes to conventional central bank activities, such as adjusting the discount rate or reserve requirements, or more unconventional ones, such as quantitative easing (QE).
BREAKING DOWN 'Tapering'
As a financial term, tapering is best known in the context of the Federal Reserve’s quantitative easing program. The program involved a large-scale bond-buying program that aimed to support struggling economic conditions.

Central banks can employ a variety of policies to improve growth, and they must balance short-term improvements in the economy with longer-term market expectations. If the central bank tapers its activities too quickly, it may send the economy into a recession. If it does not taper its activities, it may lead to high inflation.
Quantitative Easing and the 2007 Financial Crisis

In reaction to the 2007 financial crisis, the Federal Reserve began to purchase assets with long maturities to lower long-term interest rates. This activity was undertaken to entice financial institutions to lend money, and it began when the Federal Reserve purchased mortgage-backed securities. In 2013, Ben Bernanke commented that the Federal Reserve would lower the amount of assets purchased each month if economic conditions, such as inflation and unemployment, were favorable.
Tapering the Quantitative Easing Program

The tapering, or reduction, of the QE program that was instituted in response to the 2007 financial crisis began the process of tapering down in 2013. This involved schedule reductions in predetermined amounts through 2013, continuing through the majority of 2014. For example, in January 2014, the Federal Reserve announced its intention to reduce the program from an amount of $75 billion to $65 billion in February of that same year. Ultimately, the reductions continued until the program concluded in October 2014, as the involved economies were deemed to require less financial stimulus than in prior years.
Philosophy Behind Tapering

Being open with investors regarding future bank activities helps set market expectations. This is why central banks typically employ a gradual taper rather than an abrupt halt to loosen monetary policies. Central banks reduce market uncertainty by outlining their approach to tapering, and by specifying under what conditions that tapering will either continue or discontinue. In this regard, any foreseen reductions are spoken of in advance, allowing the market to begin making adjustments prior to the activity actually taking place.
Central Bank

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A central bank, or monetary authority, is a monopolized and often nationalized institution given privileged control over the production and distribution of money and credit. In modern economies, the central bank is responsible for the formulation of monetary policy and the regulation of member banks.

The central bank of the United States is the Federal Reserve System, or “the Fed,” which Congress established with the 1913 Federal Reserve Act.
BREAKING DOWN 'Central Bank'

Central banks are inherently non-market-based or even anticompetitive institutions. Many central banks, including the Fed, are often touted as independent or even private. However, even if a central bank is not legally owned by the government, its privileges are established and protected by law.

The critical feature of a central bank — distinguishing it from other banks — is legal monopoly privilege for the issuance of bank notes and cash; privately owned commercial banks are only permitted to issue demand liabilities, such as checking deposits.
Functions of Central Banks

The normative justification for central banking rests on three critical factors. First, the central bank manages the growth of national monetary aggregates in an attempt to guide economic policy, often with the aim of full employment. The bank also acts as an emergency lender to distressed commercial banks and other institutions. Finally, a central bank offers much greater financing flexibility the central government by providing a politically attractive alternative to taxation.

Central banks conduct standard monetary policy by manipulating the money supply and interest rates. They regulate member banks through capital requirements, reserve requirements and deposit guarantees, among other tools.

The first prototypes for modern central banking were the Bank of England and the Swedish Riksbank in the 17th century. The Bank of England was the first to acknowledge the role of lender of last resort. Other early central banks, notably Napoleon’s Bank of France and Germany's Reichsbank, were established to finance expensive government military operations.
Central Banking in the United States

It was principally because European central banks made it easier for governments to grow, wage war and enrich special interests that many of America's founding fathers, most passionately Thomas Jefferson, opposed central banking. Despite these objections, the early United States used both official central banks and numerous state-chartered banks, except for the “free-banking period” between 1837 and 1863.

The National Banking Act of 1863 created a network of national banks and a single U.S. currency, with New York as the central reserve city. The United States subsequently experienced a series of bank panics in 1873, 1884, 1893 and 1907. In response, the United States established the Federal Reserve System and spread 12 Federal Reserve Banks throughout the country to stabilize financial activity.

The new Fed helped finance World War I and World War II by purchasing Treasury bonds. Unfortunately, even more severe financial crises persisted in the Fed era, notably in 1929, 1937, 1980 and 2007. Despite the best efforts of the Federal Reserve and its board of governors, stable central bank policy remains elusive.
Easy Money


Easy money, in academic terms, denotes a condition in the money supply. Easy money occurs when the U.S. Federal Reserve allows cash flow to build up within the banking system as this lowers interest rates and makes it easier for banks and lenders to loan money. Therefore, borrowers can acquire money more easily from lenders.
BREAKING DOWN 'Easy Money'

Easy money occurs when a central bank wants to make money flow between banks more easily thanks to lower interest rates. When banks have access to more money, interest rates to customers go down because banks have more money they want to invest. The Federal Reserve typically lowers interest rates and eases monetary policy when the agency wants to stimulate the economy and lower the unemployment rate. The value of securities often initially rises during periods of easy money, when money is less expensive. But if this trend continues long enough, it can eventually reverse due to fear of inflation. Easy money is also known as cheap money, easy monetary policy and expansionary monetary policy.
Inflation

The Federal Reserve must carefully weigh any decisions to raise or lower interest rates based on inflation. If an easy monetary policy may cause inflation, banks might keep interest rates higher to compensate for increased costs of goods and services. Borrowers might be willing to pay higher interest rates because inflation reduces the amount of a currency's value. A dollar does not buy as much during inflation, so the lender may not reap as much profit compared to a time of low inflation.
How Easy Money Works

An easy monetary policy may lead to lowering the reserve ratio in banks. This means banks get to keep less of their assets in cash, which leads to more money going to lenders. Because more cash goes out to borrowers, the interest rates lower. Easy money has a cascade effect that starts at the Federal Reserve and goes down to consumers.

As an example, during an easing of monetary policy, the Federal Reserve may instruct the Federal Open Market Committee (FOMC) to purchase Treasury-backed securities on the open market. The purchase of these securities gives money to the people who sold them on the open market. The sellers then deposit any excess funds into a savings account. The extra money in savings accounts gives banks more money to invest.

Banks can lend the new deposits or invest them in other ways because most of this new money comes to lenders above the minimum reserve amount. Lenders then earn money on the interest for loans and deposit money into other bank accounts. Borrowers spend the loans on whatever they choose, which, in turn, stimulates other economic activities. The process continues indefinitely until such time the Federal Reserve decides to tighten monetary policy.
Bank Rate

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A bank rate is the interest rate at which a nation's central bank lends money to domestic banks, often in the form of very short-term loans. Managing the bank rate is method by which central banks affect economic activity. Lower bank rates can help to expand the economy by lowering the cost of funds for borrowers, and higher bank rates help to reign in the economy when inflation is higher than desired.
BREAKING DOWN 'Bank Rate'
In the United States, the bank rate is often referred to as the federal funds rate or the discount rate. In the United States, the Board of Governors of the Federal Reserve System sets the discount rate as well as the reserve requirements for banks. The Federal Open Market Committee (FOMC) buys or sells Treasury securities to regulate the money supply. Together, the federal funds rate, the value of Treasury bonds and reserve requirements have a huge impact on the economy. The management of the money supply in this way is referred to as monetary policy

Discount Rate Versus Overnight Rate

The discount rate, or bank rate, is sometimes confused with the overnight rate. While the bank rate refers to the rate the central bank charges banks to borrow funds, the overnight rate refers to the rate banks charge each other when they borrow funds among themselves. Banks borrow money from each other to cover deficiencies in their reserves.

Banks are required to have a certain percentage of their deposits on hand as reserve. If they don't have enough cash at the end of the day to satisfy their reserve requirements, they borrow it from another bank at the overnight rate. If the discount rate falls below the overnight rate, banks typically turn to the central bank, rather than each other, to borrow funds. As a result, the discount rate has the potential to push the overnight rate up or down.
How the Bank Rate Affects Consumer Interest Rates

As the bank rate has such a strong effect on the overnight rate, it also affects consumer lending rates. Banks charge their best, most creditworthy customers a rate that is very close to the overnight rate, and they charge their other customers a rate that is a bit higher. For example, if the bank rate is 0.75%, banks are likely to charge their customers relatively low interest rates. In contrast, if the discount rate is 12% or a similarly high rate, banks are going to charge borrowers comparatively higher interest rates.
Negative Interest Rate Policy (NIRP)

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A negative interest rate policy (NIRP) is an unconventional monetary policy tool whereby nominal target interest rates are set with a negative value, below the theoretical lower bound of zero percent.
BREAKING DOWN 'Negative Interest Rate Policy (NIRP)'

During deflationary periods, people and businesses hoard money instead of spending and investing. The result is a collapse in aggregate demand which leads to prices falling even farther, a slowdown or halt in real production and output, and an increase in unemployment. A loose or expansionary monetary policy is usually employed to deal with such economic stagnation. However, if deflationary forces are strong enough, simply cutting the central bank's interest rate to zero may not be sufficient to stimulate borrowing and lending. (See also: How Interest Rates Can Go Negative.)

A negative interest rate means the central bank and perhaps private banks will charge negative interest: instead of receiving money on deposits, depositors must pay regularly to keep their money with the bank. This is intended to incentivize banks to lend money more freely and businesses and individuals to invest, lend, and spend money rather than pay a fee to keep it safe.
Examples

An example of a negative interest rate policy would be to set the key rate at – 0.2%, such that bank depositors would have to pay two-tenths of a percent on their deposits instead of receiving any sort of positive interest.

    The Swiss government ran a de facto negative interest rate regime in the early 1970s to counter its currency appreciation due to investors fleeing inflation in other parts of the world.
    In 2009 and 2010 Sweden and in 2012 Denmark used negative interest rates to stem hot money flows into their economies.
    In 2014 the European Central Bank (ECB) instituted a negative interest rate that only applied to bank deposits intended to prevent the Eurozone from falling into a deflationary spiral.

Theoretically, targeting interest rates below zero will reduce the costs to borrow for companies and households, driving demand for loans and incentivizing investment and consumer spending. Retail banks may choose to internalize the costs associated with negative interest rates by paying them, which will negatively impact profits, rather than passing the costs to small depositors for fear that otherwise they will move their deposits into cash. (For more, see: Negative Interest Rates and QE: 3 Economic Risks.)

Though fears that bank customers and banks would move all their money holdings into cash (or M1) did not materialize, there is some evidence to suggest that negative interest rates in Europe cut down interbank loans.  To stay on top of the latest finance and investing lingo, subscribe to our Term of the Day newsletter.
Accommodative Monetary Policy


When a central bank (such as the Federal Reserve) attempts to expand the overall money supply to boost the economy when growth is slowing (as measured by GDP). This is done to encourage more spending from consumers and businesses by making money less expensive to borrow by lowering the interest rate. Furthermore, the Federal Reserve also has the authority to purchase Treasuries on the open market to infuse capital into a weakening economy.

Also known as an "easy monetary policy".
BREAKING DOWN 'Accommodative Monetary Policy'

The Federal Reserve adopted an accommodative monetary policy during the late stages of the bear market that began in late 2000. When the economy finally showed signs of a rebound, the Fed eased up on the accommodative measures, eventually moving to a tight monetary policy in 2003.
Tight Monetary Policy

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Tight monetary policy is a course of action undertaken by the Federal Reserve to constrict spending in an economy that is seen to be growing too quickly or to curb inflation when it is rising too fast. The Fed tightens policy or makes money tight by raising short-term interest rates through policy changes to the discount rate, also known as the federal funds rate. Increasing interest rates, increases the cost of borrowing and effectively reduces its attractiveness.

BREAKING DOWN 'Tight Monetary Policy'
Central banks around the world use monetary policy to regulate specific factors within the economy. Central banks most often use the federal funds rate as a leading tool for regulating market factors. Tightening policy occurs when central banks raise the federal funds rate, and easing occurs when central banks lower the federal funds rate.

The federal funds rate is used as a base rate throughout global economies. It refers to the rate at which federal banks lend to each other and is also known as the discount rate. An increase in the federal funds rate is followed by increases to borrowing rates throughout the economy. Rate increases make borrowing less attractive as interest payments increase with increasing rates. It affects all types of borrowing including personal loans, mortgages and interest rates on credit cards. An increase in rates also makes saving more attractive as savings rates also increase in an environment with tightening policy.
Open Market Treasury Sales

In a tightening policy environment, the Fed can also sell Treasuries on the open market in order to absorb some extra capital during a tightened monetary policy environment. This effectively takes capital out of the open markets as the Fed takes in funds from the sale with the promise of paying the amount back with interest. In a tightening monetary policy environment a reduction in the money supply is a factor that can significantly help to slow or keep the domestic currency from inflation. The Fed often looks at tightening monetary policy during times of strong economic growth.

An easing monetary policy environment serves the opposite purpose to tightening monetary policy. In an easing policy environment, the central bank lowers rates to stimulate growth in the economy. Lower rates lead consumers to borrow more, also effectively increasing the money supply.

Many global economies have lowered their federal funds rates to zero, and some global economies are in negative rate environments. Both zero and negative rate environments benefit the economy through easier borrowing. In an extreme negative rate environment, borrowers even receive interest payments, which can create significant demand for credit.
Inflation

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Inflation is the rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of currency is falling. Central banks attempt to limit inflation, and avoid deflation, in order to keep the economy running smoothly.
BREAKING DOWN 'Inflation'

As a result of inflation, the purchasing power of a unit of currency falls. For example, if the inflation rate is 2%, then a pack of gum that costs $1 in a given year will cost $1.02 the next year. As goods and services require more money to purchase, the implicit value of that money falls.

The Federal Reserve uses core inflation data, which excludes volatile industries such as food and energy prices. External factors can influence prices on these types of goods, which does not necessarily reflect the overall rate of inflation. Removing these industries from inflation data paints a much more accurate picture of the state of inflation.

The Fed's monetary policy goals include moderate long-term interest rates, price stability and maximum employment, and each of these goals is intended to promote a stable financial environment. The Federal Reserve clearly communicates long-term inflation goals in order to keep a steady long-term rate of inflation, which in turn maintains price stability. Price stability, or a relatively constant level of inflation, allows businesses to plan for the future, since they know what to expect. It also allows the Fed to promote maximum employment, which is determined by nonmonetary factors that fluctuate over time and are therefore subject to change. For this reason, the Fed doesn't set a specific goal for maximum employment, and it is largely determined by members' assessments. Maximum employment does not mean zero unemployment, as at any given time people there is a certain level of volatility as people vacate and start new jobs.

Monetarism theorizes that inflation is related to the money supply of an economy. For example, following the Spanish conquest of the Aztec and Inca empires, massive amounts of gold and especially silver flowed into the Spanish and other European economies. Since the money supply had rapidly increased, prices spiked and the value of money fell, contributing to economic collapse.
Historical Examples of Inflation and Hyperinflation

Today, few currencies are fully backed by gold or silver. Since most world currencies are fiat money, the money supply could increase rapidly for political reasons, resulting in inflation. The most famous example is the hyperinflation that struck the German Weimar Republic in the early 1920s. The nations that had been victorious in World War I demanded reparations from Germany, which could not be paid in German paper currency, as this was of suspect value due to government borrowing. Germany attempted to print paper notes, buy foreign currency with them, and use that to pay their debts.

This policy led to the rapid devaluation of the German mark, and with it, hyperinflation. German consumers exacerbated the cycle by trying to spend their money as fast as possible, expecting that it would be worth less and less the longer they waited. More and more money flooded the economy, and its value plummeted to the point where people would paper their walls with the practically worthless bills. Similar situations have occurred in Peru in 1990 and Zimbabwe in 2007-2008.
Inflation and the 2008 Global Recession

Central banks have tried to learn from such episodes, using monetary policy tools to keep inflation in check. Since the 2008 financial crisis, the U.S. Federal Reserve has kept interest rates near zero and pursued a bond-buying program – now discontinued – known as quantitative easing. Some critics of the program alleged it would cause a spike in inflation in the U.S. dollar, but inflation peaked in 2007 and declined steadily over the next eight years. There are many, complex reasons why QE didn't lead to inflation or hyperinflation, though the simplest explanation is that the recession was a strong deflationary environment, and quantitative easing ameliorated its effects.
Inflation in Moderation: Harms and Benefits

While excessive inflation and hyperinflation have negative economic consequences, deflation's negative consequences for the economy can be just as bad or worse. Consequently, policy makers since the end of the 20th century have attempted to keep inflation steady at 2% per year. The European Central Bank has also pursued aggressive quantitative easing to counter deflation in the Eurozone, and some places have experienced negative interest rates, due to fears that deflation could take hold in the eurozone and lead to economic stagnation. Moreover, countries that are experiencing higher rates of growth can absorb higher rates of inflation. India's target is around 4%, Brazil's 4.5%.
Real World Example of Inflation

Inflation is generally measured in terms of a consumer price index (CPI), which tracks the prices of a basket of core goods and services over time. Viewed another way, this tool measures the "real"—that is, adjusted for inflation—value of earnings over time. It is important to note that the components of the CPI do not change in price at the same rates or even necessarily move the same direction. For example, the prices of secondary education and housing have been increasing much more rapidly than the prices of other goods and services; meanwhile fuel prices have risen, fallen, risen again and fallen again—each time very sharply—in the past ten years.

Inflation is one of the primary reasons that people invest in the first place. Just as the pack of gum that costs a dollar will cost $1.02 in a year, assuming 2% inflation, a savings account that was worth $1,000 would be worth $903.92 after 5 years, and $817.07 after 10 years, assuming that you earn no interest on the deposit. Stuffing cash into a mattress, or buying a tangible asset like gold, may make sense to people who live in unstable economies or who lack legal recourse. However, for those who can trust that their money will be reasonably safe if they make prudent equity or bond investments, this is arguably the way to go.

There is still risk, of course: bond issuers can default, and companies that issue stock can go under. For this reason it's important to do solid research and create a diverse portfolio. But in order to keep inflation from steadily gnawing away at your money, it's important to invest it in assets that can be reasonably be expected to yield at a greater rate than inflation.

For further reading on this subject, check out the Inflation Tutorial.

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