What the hell is QE, Forward Guidance and NIRPs? Let me tell you.
Most people are daunted by economics. It just seems so mathy and filled with academic jargon. But for as complex as it may be, you my friend are a participating actor in the economy, whether you like it or not. And that means it is important to know a thing or two about it. Now, a big part of economics is money (duh). Building on this, few people know how Monetary Policy works in the United States. You’ve got your conventional approach, which is all about adjusting interest rates, open market operations, and setting bank reserve requirements. And then you’ve got the black sheep policies of Quantitative Easing (QE), Forward Guidance and negative interest rates (among others). The US Fed is a large proponent of the unconventional approach, which is today’s topic.
Quantitative Easing (QE)
QE is one of the Monetary Policy tools that the Fed uses to keep cash liquid and moving throughout the economy. When the Fed implements QE, it buys a bunch of securities in very large chunks (like treasuries and mortgage-backed securities), with the aim to decrease interest rates, help lenders seek out investors, and boost the overall money supply. Through significant purchases of financial assets, the Fed’s goal is to decrease long-term interest rates to keep credit channels open and encourage consumer spending in times of economic crisis. QE differs from traditional monetary mechanics in that the conventional approach only targets short-term rates, whereas QE focuses on the future. QE was initially embraced by the Fed during the 2008 Great Recession.
Simply put, forward guidance is when consumers are equipped with foresight on actions that will affect future interest rates. This means that they are guided in advance by central banks (The Fed) that will either clearly relay their expectations on future rates by communicating monetary policy evolution over time, or by maintaining a baseline of consistently low interest rates despite changes in economic circumstances. Forward guidance seeks to establish credibility with people in the economy via consistent policy and transparency. This policy may not always work: in fact, it might not have an effect on expectations generally, and the way that the policy is interpreted by consumers may work against economic progress. If, for example, rates stay low for longer than anticipated, this may affect consumer confidence. On the upside, this policy can be beneficial if consumers expect that the forward guidance will help to increase inflation and GDP growth.
Negative Interest Rates
Negative interest rates policies (NIRPs) have a simple logic: they induce people to stop hoarding cash––which will rebuke its value due to the negative deposit rate––and instead encourage people to borrow, spend, and invest. For example, the European Central Bank and Bank of Japan have leveraged negative interest rates in order to reduce excess banks reserves and encourage increased lending and purchasing of other financial assets. However, negative interest rates have been at constant battle with economists. A big concern surrounding negative interest rates is that if banks turn them down on deposits, and over to retail depositors, the lending spread can dip into negative territory. This occurs because loan returns wouldn’t have the capacity to cover holding deposit costs, which could diminish the profits of banks and intermediaries, thus instigating a financial meltdown.
In today’s blog, I gave you an overview of Unconventional Monetary Policy. QE, Forward Guidance, and NIRPs are just some of the interesting tools that Central Banks use when the financial climate gets shaky. And now, you know Monetary Policy a bit better.