In March 2020, the Federal Reserve, or Fed, cut its target interest rate to zero in response
to the economic slowdown caused by the Covid-19 pandemic.
This led some to wonder if the Fed was all out of ammoť in its attempt to spark economic
growth.
But when faced with an economic crisis, the Fed has many tools at its disposal to boost
economic activity and keep the money flowing.
One of those tools is called quantitative easing, or Q-E.
QE is a tool used by central banks to provide liquidity and keep money moving through the
economy.
In the United States, the Fed has typically done this by purchasing securities like longer-term
Treasuries and mortgaged-backed securities on the open market.
The intent is to keep rates lower and help lenders find investors.
So how is QE different from the Fed's usual tools?
The Fed is charged with managing the U.S. monetary policy, which means changing the
money supply in an attempt to manage economic growth and inflation.
The Fed typically does this using the federal funds rate, which is a very short-term interest
rate that helps determine borrowing costs for banks.
The Fed sets a lower target for the short-term rates through a process called open market
operations.
It essentially creates or quote-unquote prints money by buying very short-term Treasuries,
which pushes the rate lower.
Normally, that lower short-term rate can lower interest rates across the board.
This makes borrowing for people and businesses cheaper, ideally boosting the economy.
But during a financial crisis, economic worries may hamper the trading and lending that lowers
the longer-term rates.
When this happens, the Fed may engage in QE.
It does this by buying other assets like longer-term Treasuries, mortgage-backed securities, or
commercial debt.
Buying these assets can pull the yield lower in targeted areas.
The goal is to find places where money isn't flowing and remove the logjam.
The Fed used several rounds of QE to help the economy recover from the financial crisis
of 2008, buying billions in Treasuries and mortgage-backed securities between 2008 and
2014.
In response to the Covid-19 crisis in 2020, the Fed again instituted QE.
This time it announced essentially unlimited QE, assuring investors it would continue to
help the economy as long as it was needed.
The Fed also expanded the program to include buying corporate bonds and bond funds.
In addition to QE, the Fed also responded to the coronavirus by reinstating 2008 crisis
measures like lending programs for banks, large corporations, and foreign central banks.
It also loosened some financial regulations introduced after the 2008 financial crisis
and introduced new lending programs for small- and medium-size businesses and state and local
governments.
So, the Fed is clearly not out of ammo when it cuts the federal funds rate to zero.
However, printing all this money may come at a cost.
The U.S. dollar, like any asset, can fall in value if there's an enormous increase
in supply.
Some economists fear that QE could result in hyperinflation, or a fast rise in the costs
of goods and services.
Since the 2000s, broad inflation has been kept in check by free trade, globalization,
and higher productivity, which lowered the costs of many goods and raw materials.
However, prices of assets like stocks, bonds, and housing have seen tremendous inflation.
Additionally, purchases that often require loans such as college, housing, and cars have
seen a dramatic rise in prices.
While there are numerous factors that can impact the prices of goods and services, some
economists point to Fed policies as a cause.
Along with inflation, some economists have argued that the increased money supply and
the low cost of borrowing could result in a debt trap, where servicing the rising
debt levels may make it harder for businesses and individuals to spend and invest in ways
that lead to economic growth.
Finally, other economists argue that inflated asset prices caused by QE primarily benefit
the wealthy rather than supporting broader economic growth driven by middle-class consumption.
Even if its long-term impacts remain unclear, QE can have shorter-term impacts on your portfolio.
If QE is successful, then the economy could grow, and stock prices would rise.
But the picture is different for bond investors.
Generally, bond prices tend to rise when interest rates go down or when the Fed initiates QE.
But if the federal funds rate is at zero, it may be hard for bond prices to go higher,
although some countries have experimented with negative interest rates.
In response to rates going to zero, investors may instead seek yield by investing in corporate
bonds and dividend-paying stocks.
But both of these moves mean potentially taking on more risk.
In addition, if inflation does occur, precious metals have historically been a hedge against
inflation.
Some investors may turn to gold and silver commodities and stocks for potential growth.
QE is meant to help the economy grow, but it's no guarantee.
So, investors should have a plan for how they'll respond to the potential effects of QE.
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