About a year after the Sept. 11 terrorist attacks, Federal Reserve Chairman Ben Bernanke (then a Fed governor) described what the government might do to prevent Japanese-style deflation if falling prices became a threat in the United States. Referencing earlier comments from economist Milton Friedman, Bernanke said the Fed could simply have money printed and drop the fresh bucks from a helicopter. Thus was born Bernanke’s not-so-flattering moniker, “Helicopter Ben.”
Dollar-laden helicopters overhead might also be an apt image for what’s known as quantitative easing, or Fed buying of fixed-income assets with freshly minted money. The Fed’s decision in September to rev up the monetary engines for a third flight will have a significant near-term impact on stock prices. Potentially, though, so-called QE3 also might cause much higher inflation if and when economic growth accelerates and loan demand normalizes.
Quantitative easing is a highly controversial and historically unorthodox monetary weapon whose ultimate impact on asset and goods prices is largely unknown. It’s also a tool that many investors might not fully understand. So let’s try.
At About.com — Economics, you’ll find a basic description of QE and an explanation of how it differs from the Fed’s most conventional policy tool, benchmark interest rates. For a more detailed explanation, check out Ciovacco Capital Management’s superb video and graphic, which includes comments from Bernanke and other monetary authorities.
At Bankrate.com you’ll find a useful interactive history of American QE through its second round, which concluded in June 2011. The site displays what happened, what the Fed wanted to happen and what actually happened to mortgage interest rates over that period.
But the Fed isn’t alone in using QE to revive a moribund economy. In March 2001, the Bank of Japan finally resorted to quantitative easing, more than a decade after the popping of real estate and equity bubbles triggered deflation. The Bank of England also has been using a form of QE; visit the BOE’s website for a four-minute visual representation of the QE process. Critics complain that QE is mostly risk with little reward and cite lingering output gaps in the U.S., the U.K and Japan as evidence.
An August 2012 research paper by William White, the former chief economist at the Bank for International Settlements, also argues that ultra-easy monetary policy has several unintended consequences, including the inefficient allocation of capital. Yet global economic conditions might be even worse if it weren’t for quantitative easing. According to a January 2011 study by the Federal Reserve Bank of San Francisco, QE cut the unemployment rate by 1.5 percentage points and probably prevented deflation. A more recent San Francisco Fed paper, however, revealed that declines in Treasury yields and mortgage interest rates have been smaller with each successive round of monetary easing.
Like the reaction of the human body to medications, perhaps economies also become inured to the simulative effects of a monetary drug. If so, policymakers might be running out of treatments for an economic malady that’s defied a cure.