Saturday, June 22, 2013

Role of Quantitative Easing (QE) in revival of US Economy

Quantitative Easing (QE), or commonly referred to as open market operation (OMO) is a economic scenario, wherein the central bank of the country engages into buying (or selling) of government securities from (to) commercial banks and financial institutions to increases (or reduces) the quantum of liquidity in the economy.
In US, the committee of Federal Reserve (US Central Bank), Federal Open Market Committee (FOMC) is responsible for implementing monetary policy. It undertakes quantitative easing mechanism, with the objective to reduce long term interest rate and to revive the economic activities in US. The federal bank began its quantitative easing activity in December 2008. As announced in June 2013, the Fed is likely to end its QE program by end of 2014.  

Until now, total influxes of capital through QE are:
QE1: The buying of $1.35 trillion of mortgage-backed securities plus $300 billion of Treasuries.
QE2: The buying of $600 billion of Treasuries.
QE3/QE4: An open-ended commitment to buy $40 billion /month agency mortgage backed securities and $45 billion / month of longer-dated Treasuries until unemployment reach 6.5% and/or inflation reaches acceptable level
Operation Twist: The purchase of $667 billion of longer-dated Treasuries.

Effects of QE on US economy and financial instruments
By undertaking, QE program, the federal bank was able to increase the liquidity in the economy and thereby improve the lending capacity of banks and financial institutions. By increasing the quantum of money, it would reduce the interest rate for borrowing and thereby reduce the liquidity premium on most liquid bonds.
The effect of such mechanism to lower interest rate in short run is felt across all fixed income instruments. However, based on expectation theory, the forward rates are function of series of current spot rates. So the expectation about future rates is based on current spot rate. So, the impact of lower interest rate will be felt on the interest rate of fixed income instruments with intermediate maturity (which is expected to be in range of 2-5 years). The impact of such action is not likely to affect long term maturity security as Fed would keep low interest rate only till stage the economy shows sign of recovery, beyond which Fed will sell of its accumulated securities.   

US Treasury securities
By in-fluxing the funds, the Fed is able to lower the interest rate on US treasury securities, which are the safest investment. Further, the US treasury rate forms the basis of interest rate of other securities traded in the country. So, by lowering the treasury interest rate, the Fed can indirectly bring down the interest rate on all other debt instruments.
Corporate Bonds
Corporate bonds or any lower grade bonds such as Baa bonds have higher default risk then Treasury bonds. With in-flux of funds through QE, there was enough liquidity and more likelihood that the organization will make timely payment of principal and interest on such bonds, so the default risk was lower and hence the interest rate on such instruments has fallen.
Bonds and other fixed income instruments
Along with treasury securities, the QE also involved purchase of Agency bonds or Agency MBS. This enabled fed to reduce the duration risk (which is change in value of bond per unit change in interest rate risk) in the hands of investors and thereby reducing yield on long-maturity bond. The effect of reduction in yield of long term assets is proportional to duration of the bonds. So the bonds with longer maturity period have larger effect of duration risk, as these bonds react more dramatically to interest rate changes. Further, QE provided safety of repayment for Agency bonds and Agency MBS, thereby decreasing the yield on such instruments.  

Benefits of lower interest rate
  • By keeping interest rate low, the Fed had objective to lower house-loan rates to encourage and thereby encourage home buying activities.
  •  With low interest rate, Corporate can easily issue debt or refinance it at low rates. The low interest costs accompanied with tax deductibility of interest make bond issue attractive to equity
So, through series of activities, Fed was able to reduce the overall interest rate and revive the US economy to much extent.

Reference
Arvind Krishnamurthy and Annette Vissing-Jorgensen (2011), ‘The Effects of Quantitative Easing on Interest Rates’, www.ssrn.com, accessed on June 21, 2013
The Effect of Quantitative Easing, AWA advanced wealth advisors, http://awadvisors.com/2013/02/11/the-effect-of-quantitative-easing/, accessed on June 21, 2013
Fed statement on monetary policy (June 19, 2013), Press Release – Federal Reserve System, http://www.federalreserve.gov/newsevents/press/monetary/20130619a.htm, accessed on June 21, 2013