With uncertainty on the rise globally, talk of a new round of quantitative easing — it would be QE3 — is increasingly common. QE is a policy where the U.S. Federal Reserve System creates additional money through its open market operations.
Last year the Fed announced QE2, a policy of buying $600 billion in bonds, meaning that $600 billion in new money will have been created by the time the program ends in June. While it is commonly said that the Fed prints new money to pay for these bonds, the bonds are paid for via bookkeeping entries, sort of an electronic bill pay system between the Fed and banks who sell the bonds. That’s even cheaper than printing stacks of $100 bills. Reason explains in more detail how QE works:
One simplified way to describe how this round of quantitative easing will work is this: The Fed doles out $600 billion in made-up money to the world’s biggest banks, who make a tidy profit on the sale and then split that profit up into bonuses. As Reuters financial blogger Felix Salmon writes, “We’re not exactly helping the unemployed here.”
The actual process is slightly more complicated, but not much more appealing. Once the members of the Federal Open Market Committee vote to buy additional bonds, the Fed schedules a series of sales, and notifies the banks on its list of primary dealers — 18 very large banks. Those banks then buy up bonds with the intention of selling them at higher rates to the Fed. And then when the scheduled sales come around, they trade their store of bonds for money that the Fed has newly created, as The Washington Post explained, “essentially out of thin air.” Interest rates go down. Inflation goes up. Investors, knowing that money is cheap now and might not be worth as much later, start to spend. The economy gets back in gear.
At least that’s the idea. It’s not the first time the Fed has pursued the QE strategy (hence QE2), and the first go-round wasn’t an obvious success. When the financial crisis first landed, the Fed pumped $1.7 trillion into the system, yet failed to lift the economy out of its sluggish state. By the time this round of quantitative easing ends, the Fed will have added almost $3 trillion to the money supply — and that’s if it quits with $600 billion.
One major worry is that all that extra currency will only lead to out of control inflation.
For another explanation of QE and whether it works, a video from last November explains.