What is QE3 (Quantitative Easing) and How Does it Affect You?

Last month Federal Reserve Chairman Ben Bernanke announced the roll out of QE3—the third installment of a plan to intervene more directly into the financial sector of the U.S. economy.

We hear and read a lot about it in the media and on the web, but how much does it affect us?

As individuals, very little; but collectively, the effect is more substantial.

What is QE (quantitative easing)?

Quantitative easing involves the Federal Reserve making unusual increases into the monetary system in order to stimulate economic growth.  Since credit is what moves so much of the country—think mortgages, auto loans, student loans and credit cards—this is where the involvement is most substantial.

The Fed does this by taking steps to lower interest rates and free up bank liquidity so that banks are free to make new loans.

QE1 and QE2

Though it wasn’t called “QE1” when it first came out in 2008, the first round of quantitative easing centered on buying up distressed loans from banks.  Those loans were sitting on the banks’ balance sheets, tying up capital and making the banks hesitant to make new loans.

In the first round, the Fed bought up $600 billion worth of bad loans from the banks, and while it didn’t seem to stimulate the economy, there’s a real possibility that it kept the economy from getting as bad as it could have.

The actual buying of bad debt from the banks may have helped improve their balance sheets, but at least as important was the fact that the Fed was taking action.  Decisive action by the Fed usually builds confidence in the business and financial communities, as well as in the population at large, that substantial steps are being taken to fix what ever is wrong.

The second round of easing—“QE2”—was rolled out in November of 2010.  It involved the Fed purchasing $600 billion of Treasury Notes (federal government debt securities that mature between two and ten years).  By artificially increasing demand for government securities, interest rates were kept lower than they might have other wise been.

What is QE3? – the latest edition

The two principal components of QE3 are (1) a commitment to keep the federal funds rate near zero through 2015, and (2) the monthly purchase by the Federal Reserve of $40 billion in mortgage backed securities.

The net effect of those two actions are to make sure that interest rates continue to be low—with the idea that low rates stimulate economic growth—and that banks continue to stay liquid so they can lend.

How will QE3 affect you?

No one can predict the future and know exactly how QE3 will play out, but we can get some clues from the last two episodes.  And while none of this will benefit us in a direct sense—we won’t be getting larger tax refunds or higher paychecks—it might help in indirect ways by improving the economy.

More predictability in the economy.

Confidence is a huge part of what drives the economy.  By launching QE3, the Fed signaled that its policies of recent years will continue.  That continuity gives banks and businesses some sense of direction in a still wobbly economy.

At a minimum, they know that the Fed stands ready to intervene to cover the weak spots.

A stronger stock market.

Though there isn’t a direct connection, it’s generally thought that money injected into the economy by the Federal Reserve ultimately finds it way into the stock market.

This plays out in three ways:

1. Lower interest rates make stocks more attractive than fixed income investments, meaning that investors will have a preference for stocks because of their potential for far greater returns
2. Relieving the banks of bad loans frees them up to make new loans that will both increase corporate earnings and/or increase the flow of money into stocks
3. Actions taken by the Fed increase investor confidence to invest.

Continued low interest rates.

This is a mixed scenario.  Low interest rates are thought to stimulate borrowing which strengthens the economy, and it’s a direct benefit to you if you’re a borrower.  But if you’re a saver, low rates are a negative, especially if you are retired and/or have preference for fixed income investments over equities.

A stronger job market.

Because of all of the above, companies may be more willing to hire than they would otherwise.  That can mean more job opportunities and, hopefully, higher pay.

Finally

As you can see, we should expect little in the way of direct benefit from QE3.  But the positive affect is has on lending and business in general might produce trickle down benefits that can help us in a more tangible way.

There are different opinions on this. What are your thoughts on QE3—or even on all three QE’s?  Good, bad or irrelevant?