Quantitative Easing 2 or QE2 refers to the second round of quantitative easing performed by the Federal Reserve. QE2 was essentially a monetary policy tool used to foster economic development in the United States in response to the global recession of 2007/2008. The policy was established and integrated in the last quarter of 2010 to foster economic recovery.
How QE2 Came About
As a response to the 2008 Global Financial Crisis, the Federal Reserve decided to initiate QE1 (the first round of quantitative easing) to counter the financial crisis. During the QE1 phase of open market operations, the Federal Reserve purchased $500 billion in securities backed by mortgages, along with another $100 billion in other debt instruments. It was done to support the mortgage and housing market.
The federal funds rate was then lowered to zero, and the Federal Reserve began making interest payments to member banks for their respective reserve requirements. QE1 was the central bank’s last resort and primary tool to combat the 2008 crisis. It lasted for over a year – from December 2008 to March 2010.
Despite the Federal Reserve’s efforts with QE1, the member banks were still not lending funds at the desired rate. The introduction of QE2 was prompted by the lack of motivation by banks to lend out more money, which would’ve ideally increased the money supply in the economy. Through QE2, the Federal Reserve initially hoped to mildly drive up inflation and increase demand, resulting in economic stimulation.
Through QE2, the Federal Reserve aimed to prevent the possibility of long-lasting deflation, as deflation (a constant decrease in prices over time) hinders overall economic expansion. The mild increase in inflation would encourage consumer spending in the present, following the premise that a slow increase in prices would encourage consumer spending in the present time to avoid the expected future price increments. The increase in inflation, ideally, was to increase demand. The Federal Reserve targeted an inflation rate of 2% (excluding volatile gas and food prices).
In June 2011, the Federal Reserve announced the end of QE2 and maintained $2 trillion worth of securities.
The Concept of Quantitative Easing
To gain a basic comprehension of QE2, it is pivotal to understand the general concept of quantitative easing.
Quantitative easing refers to the process whereby the central bank of a country (such as the Federal Reserve) purchases long-term securities from other “member” banks and issues credit to the respective banks’ reserves. The central bank creates funds to fund the purchases of securities.
Quantitative easing creates an increase in money supply throughout the economy, in conjunction with decreased long-term interest rates. The decreased interest rates encourage lending by banks, helping stimulate the economy at large.
The Mechanism of Quantitative Easing
When a central bank issues credit to a member bank, it is added to the bank’s balance sheet and provides the member bank with funds to ensure that it meets the reserve requirement. A reserve requirement is a benchmark of the amount of funds each member bank should have in its reserve at the closing of the business day. The addition of credit to the member bank’s reserves drives up the money supply, resulting in decreased interest rates.
Through this expansion of the central bank’s open market operations – i.e., the quantitative easing or the sales and purchases of securities to and from member banks – the bank can lower the federal funds rate (the interest rate at which depository institutions lend reserve balances to other depository institutions overnight on an uncollateralized basis) to zero.