Wednesday, September 9, 2009

On Fed's Quantitative Easing

Over the past year, you may have heard the term quantitative easing quite often in business news reporting. But what exactly is it?

When the Central Bank, in US case, the Federal Reserve, cut their interest to zero, and the economy is still contracting. They may start to employ a technique call Quantitative Easing. In layman's term, it is essentially the central bank start to print money to buy stuff. Normally, these stuffs include treasury bond, corporate bonds and other fixed income assets.

During the current crisis, the Fed added about $1 trillion money to our financial system (most of these $1 trillion dollar has not been printed per se, but was credited to financial institution (just like a check written by the Fed). So where did these money go. About $267 billion is used to purchase US treasury bond, and another $624 billion used to purchase mortgage back securities(MBS).

So what does this do to the economy. By buying $270 bn of treasury bond, the Fed is essentially supporting the Federal Government's $787 billion stimulus plan put in last year. Without such a purchase, the US government will need to raise extra $270 billion from the market, causing interest rate to go higher across board. So the Fed print money, hand it to the federal government, federal government spend that money on infrastructure project or give it to state, either way, some workers out there are getting their pay.

But what about the $624 billion to buy MBS? Let's take a look at MBS. First you take out a mortgage for your home, then your bank bundle your mortgage with other people's mortgage (a lot of mortgage paper), then these huge trunk of mortgage becomes a securities (one big paper). Before the Crisis, there are ready buyers of these big papers (Fannie Mae, Freddie Mac, investment banks and whatnot). But after the crisis, these people don't have the ability to buy these anymore (because they figure out some of those papers in some of the big papers are having problem, their big paper can only be sold at a loss). So what happen, mortgage would be hard to get. Then their goes the calvary, the Fed. They print money to buy those big paper, so that money can flow from big banks to local bank and to whoever wants to buy a house. That way, people can get their money if they want to buy a house, and so house price will not fell too much. Also, by buying the MBS, the Fed also supports the financial institutions who own those big papers because it kind of support the price. So those who may have to sell their MBS at a loss can now dump it to the nice Fed.

Now, is it really that simple? Can we really just print our money to spend, to lend, and be a great country? I don't know. But I don't believe in such a good deal. However, printing money seems like our only option in the short run. But don't we need to think about some long run solution too? So that we won't have to put us in a situation where printing money is the only way to save our economy.

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