Quantitative easing is a technique used by Central Banks to stimulate the economy. This monetary policy technique increases the money supply and lowers interest rates to enable banks to lend. Bank lending in turn spurs economic growth.
As part of the monetary policy, a Central Bank buys long-term securities from its member banks, thereby adding to the supply of money to the economy. Because of the new supply of money, interest rates fall, making it easier for people to borrow.
The Federal Reserve, which is the Central Bank of USA, used quantitative easing to restore stability to financial markets during the financial crisis of 2008. It used this technique again in 2020 to ease the financial pressure on the economy as a result of the COVID-19 pandemic.
On March 15, 2020, the Federal Reserve announced it would purchase $500 billion in U.S. Treasury Bills. It would also buy $200 billion in mortgage-backed securities over the next several months. On March 23, 2020, the quantitative easing purchases increased to an unlimited amount. By May 18, 2020 the balance sheet of the Federal Reserve had grown to $7 trillion. However, the policymakers did not consider this a matter of concern since inflation remained stable and other possible negative impacts could be controlled.
Even though quantitative easing a policy to stimulate the economy, particularly in times of crisis, it nevertheless has some outcomes that impact businesses negatively.
The basic premise on which quantitative easing works is that banks lend their surplus money from quantitative easing sales. However, during the COVID-19 crisis, banks did not lend the money as expected. They had legitimate fears of defaults due to deaths and repayment capability. As a result they sought more collateral that only increased the cost to the borrower. Guarantees by the government helped provide the necessary security to the banks in case of default.
In economic theory, increased money supply increases the demand for goods and services which in turn results in inflation. However, inflation results only when supply of goods and services does not keep pace with demand.
The uncertainties of the COVID-19 crisis increased the demand for essential goods and services. Businesses that provide the essential goods and services are able to stay afloat by borrowing at the lower interest rates and meeting the increased demand.
Many other business are impacted due to lower demand or no demand. As the uncertainties of COVID-19 decrease, the demand for non-essential goods and services will increase. Borrowing at lower interest rates will help these businesses meet the demand as it increases.
The annual inflation rate in the United States of America is 5.4% as of September 2021 but is expected to be around 2.6% in 2022 according to some analysts.
Quantitative easing also has the effect of devaluing the local currency. This makes exports cheaper and imports more expensive for the country. Expensive imports increase the cost of production in import-dependent industries and in those that have a high import content.
The foreign currency exchange rate is a relative measure and is determined on the comparative economic factors in the two economies. The pandemic has impacted all economies in the world but to varying degrees of severity. Consequently the US Dollar has strengthened or weakened vis-à-vis another economy. However, the analysts forecast a strong US Dollar in the near future.
Lower lending rates are conducive to business expansions and consolidations. Expansions could be “greenfield” expansions funded by borrowing from banks or the public at lower rates. Or the expansion could take place through mergers and acquisitions.
Low bank rates impact the valuations of businesses. The required rate of return or the discount rate is dependent on the prevalent risk-free rate of return. A lower risk-free rate of return (e.g. 10 year US Treasury Bills) could lower the discount rate applied to future sustainable cash flows to arrive at better valuation for a business. An acceptable valuation results in opportunities for mergers and acquisitions.
Often the availability of funds at lower rates of interest results in a bull run in the stock market. This is true of most stock markets globally, since the returns from trading in the market in the short to medium term exceed the rate of borrowing.
Institutional investors look for opportunities in the emerging markets as well and re-balance their portfolios accordingly.
Quantitative easing lowers the interest rates which directly impacts bond prices in the secondary markets for bonds. Falling interest rates vis-à-vis fixed coupon rates tends to increase the bond price. Those holding tradable bonds exit after earning higher yields while those investors who expect interest rates to fall further would buy the bonds even at higher prices.
Lower interest rates on loans also means lower interest rates available on savings. Those saving for the future are forced to look for higher returns. These are available in the traditional markets such as stocks, bonds, derivatives, or alternative investment opportunities such as virtual currencies.
It is arguable whether or not virtual currencies have an inherent value. Nevertheless, they provide short-term returns to investors and savers that far exceed the interest rates
Quantitative easing is not expected to continue indefinitely. Policy makers will seek to change this policy as leading economic indicators improve and stabilize. The policy is also not changed suddenly but is gradually withdrawn. This is known as “Tapering Off”.
While tapering off, the policymakers tend to reduce the quantity of long-term securities purchased by the Federal Reserve from member banks. They may also reduce the frequency at which long-term securities are purchased by the Federal Reserve. There may not be a specific policy announcement relating to tapering off. However, the money market operations of the Federal Reserve would provide a cue to the tapering off. Monetary Policy announcements relating to increase in interest rates may also be indicative of tapering off.
Tapering off may not have a significant impact on the economy since it should be implemented as the economy stabilizes. Nevertheless, there could be a fall in the various indices and in the value of investments made as interest rates start to rise.
Analysts predict that tapering off could start in the second half of 2022. There is still time to consider short-term investments, borrowing at lower interest rates, and expanding your business if the future does not seem bleak.
Disclaimer: This Article is for information only and readers are advised to seek professional advice before acting upon the information provided herein
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Last Updated on December 24, 2021 by admin