Written by:CurrencyWritten on:August 15, 2011 Comments
QE3, or quantitative easing 3, lingers in the back of investors’ minds.
Few investors seem to know exactly what quantitative easing really means.
We’ll take the time to explain it now.
Quantitative easing is a simple concept: a central bank “prints” money to buy long- and short-dated government debt. The goal is to drive down interest rates, boost demand for investment capital, and increase economic output.
Supply and demand are equally powerful forces in the currency and debt markets as they are in the market for shoes, toothpaste, or jelly beans. Increasing supply means lower prices. For currency, the price is not only the current price, but also the future price—interest rates.
Many think that quantitative easing 3 will never come. The Fed has agreed to make the market for dollars liquid with a promise to keep interest rates at 0-.25% for the next two years. That action alone should keep the price of money inexpensive enough to end all talk of QE3.
Effects of QE3
We can’t predict with certainty what the Federal Reserve will do to boost output, stave off deflation, and promote general economic growth. However, we can explain how QE3 will affect the markets, pending that it does eventually come:
Lower Treasury Yields – The Federal Reserve is authorized to buy US Treasuries with freshly printed dollars. When the Fed bids up the price of US Treasuries, the yield on US Treasuries moves down. This is true for any bond—price and yield are inversely-related.
Lower dollar value – By nature of any quantitative easing program, the Fed must create more dollars to buy up US Treasuries. Naturally, this results in a lower dollar value against other currencies, as the price of the currency is dictated primarily by supply and demand.
Inflation concerns – It happens every time the Fed acts to loosen monetary policy. Inflation remains low in the US, but a small group of investors worry that quantitative easing will lead to inflation. The reality is that the Fed would like to see inflation, since it has thus far failed to create any real measurable amount of it. Deflation remains a top concern.
Rising asset prices – Assets are priced into the future, whether we’re talking about stock prices, or the price for a barrel of oil. When the time value of money falls, investors can pay for earnings further out into the future. Bernanke made it clear his goal was to boost the financial markets, and that means giving lift to asset prices.
See? Economics doesn’t have to be difficult to understand!